Over the past decade, blended emerging market debt (EMD) strategies have grown from nowhere to around a US$100 billion asset class (see Figure 1). In the last few years, in particular, they have become the favoured way for investors to access EMD, receiving positive net flows whilst dedicated local and hard currency EMD universes have seen net outflows.
But what exactly constitutes a ‘blended’ emerging market debt strategy? And how should investors expect these strategies to behave? Indeed, what is the optimal long-term strategic asset allocation and what should investors expect from their managers in terms of asset allocation and risk management? In this month’s topic piece Investec looks to answer some of these fundamental questions in an attempt to offer a better understanding of this new and, attractive, entry point to emerging market debt.
Defining ‘blended’ EMD
Defining what makes a strategy blended should be easy: namely any strategy that combines both local currency and hard currency denominated debt. However, the difficulty is that most ‘pure’ local currency debt funds will at times include some form of dollar (hard currency) denominated debt. Similarly, many ‘pure’ hard currency debt funds include some allocation to local debt.
Thus, as well as having a meaningful allocation to both local and hard currency debt, one of the key attributes of a blended EM debt strategy should be the ability to dynamically allocate between asset classes with the view of outperforming a mixed local currency/hard currency benchmark. Yet many blended strategies make little or no attempt to allocate between asset classes or outperform a mixed benchmark. To illustrate this point, Investec AM examines the ‘eVestment Emerging Markets Fixed Income – Blended Currency’ universe which consists of 50 strategies described by their managers as ‘blended’. However, as Figure 2 shows, only 19 of these strategies have identified themselves with a benchmark made up of both local and hard currency emerging market debt (be this sovereign or corporate debt).
Even if we filter out strategies that do not meet our basic definition, its research shows that not all blended strategies offer a truly blended approach. "We find that most blended strategies tend to have a strong bias towards hard currency debt and also to generally being overweight risk (i.e. being long beta)".
"We believe that the bias towards hard currency debt exposure, both within benchmarks and relative to benchmarks, is due to a number of factors. First and foremost, some managers may be inexperienced in managing local currency debt, especially with regards to managing the currency exposure itself and treating it as an opportunity rather than a risk. Secondly, not all managers have the experience and capacity to open local currency accounts, manage settlement and custody, as well as taxes, for the various local markets. Finally, we envisage that some managers are adapting what were once pure hard currency EMD strategies into more typical blended approaches, a process that will take time to fully evolve".
As the asset class and blended strategies continue to evolve, along with client preferences and demands, Investec expects that the universe of blended strategies will tend to become more focused, with a similar range of benchmarks and more balanced asset allocation.
Determining an optimal strategic allocation
Not surprisingly, it is a difficult task trying to determine what the optimal long-term allocation to the various emerging market debt asset classes should be, not least because ultimately this will also depend on each individual or institutional investor’s risk preferences. "What we are able to do, however, is consider a range of factors which should at least inform our decision on the strategic asset allocation and, hopefully, give us a better understanding of what to expect from this allocation in terms of a range of likely outcomes".
"Using simulation of historical data (please see the longer white paper for more details) in combination with evaluating the size and accessibility of each component of the EMD universe, we believe that an approximately equal allocation between local and hard, which some blended strategies offer, is reasonable. While this may mean that returns are dampened by the local currency hedged bond component, historically (although not recently) this has somewhat been made up for by the currency component. Meanwhile, including corporate debt in the hard currency debt allocation should serve to dampen the overall volatility over time, although drawdowns might be expected to be slightly worse".
One could argue that we should bias the exposure to hard currency debt (as many strategies have done) given that the currency component of local debt increases the volatility and, at least recently, has not contributed much to returns. "However, we believe that this argument may be relying too much on the recent historical data and ignores the important fact that local debt is a much larger asset class than hard currency debt, yet with far less money dedicated to it. One thing we would favour is increasing the exposure to hard currency corporate debt from the 10% suggested by our simulations. This is because, once again, it is a much larger asset class than hard currency sovereign debt. Furthermore, we also believe that the hard currency corporate debt asset class will continue to grow and present investors with attractive, diversified access to new countries and sectors. Ultimately, each investor’s risk profile will be different and would thus demand different allocations. Furthermore, we have only considered this allocation from the point of view of a dollar-based investor. The analysis could be quite different for investors with other base currencies. However, a 50/50 allocation between local and hard currency debt, with a reasonable (at least 20%) allocation to corporate debt seems to us to be a good way of balancing the need to optimise risk-adjusted returns while still not chasing the crowd and investing into already well- owned asset classes", according to Investec.