Bond Compass Q2 2021

Emerging Market Debt — Indexing on the Rise

Emerging market debt (EMD) continues to be one of the most rapidly evolving asset classes in investment markets. New developments are challenging some of the traditional perceptions around how to access EMD. In particular, the case for indexed EMD exposure has grown considerably stronger.


In the past, an active management approach to investing in EMD was perceived to be the best way to gain exposure to the asset class based on a few key assumptions:

  • An indexed exposure cannot be implemented efficiently in the asset class.
  • The fixed income markets of emerging countries are inefficient; detailed fundamental knowledge should enable active managers to identify and extract value.
  • There are some obvious ‘weak’ segments of the universe that could hamper performance; active managers can avoid these.

The reality is that the majority of active managers have failed to consistently outperform their benchmarks over the longer term. More importantly, active managers have not been able to protect capital in periods of heightened volatility and drawdown; the recent COVID-19-driven sell-off and accompanying crash in oil prices provided the latest confirmation of this. The EMD universe has evolved and an indexed approach is increasingly accepted as an attractive way to harness the performance potential of this complex exposure.

Source: Barclays, JP Morgan, State Street Global Advisors, as of December 31, 2020. Values are expressed in billions of US dollars.

We undertook a comprehensive study of the active managers in the Morningstar database, tracking two flagship EMD indices: JPM GBI-EM Global Diversified Index (GBI-EM) for local currency and JPM EMBI Global Diversified Index (EMBI-G) for hard currency. The majority of active managers, both in the local and hard currency universe, have been unable to outperform their respective index over one-year, three-year, and five-year periods.

Percentage of Active Managers Who Fail to Outperform Their Benchmarks

 

1 Year (%)

3 Years (%)

5 Years (%)

Local Currency Sovereign Universe

61

79

73

Hard Currency Sovereign Universe

48

81

48

Source: Morningstar Direct, as of December 31, 2020. Past performance is not a guarantee of future results. Funds in the Morningstar universe managed to the JPM GBI-EM G Index for local currency and to the JPM EMBI-G Index for hard currency and having at least five years’ track record used for analysis. Number of funds used = 56. Net-of-fee performance shown for the Institutional share class. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable

While active managers have indeed outperformed in individual years, a key concern is their inability to consistently outperform and to protect capital during periods of significant drawdown, such as the COVID-19-related sell-off in Q1 2020.

Active Manager Performance over Discrete Years

Performance of both local and hard currency active managers appear procyclical and in line with market performance. A larger percentage of managers tend to outperform during strong years, such as 2016 and 2017, while in negative years, such as 2015 and 2018, the opposite is true.

Based on Morningstar data from the past five years, active managers seem to struggle when there is a significant directional market change from positive to negative. When both hard currency and local currency debt delivered solid returns in 2016 and 2017, a majority of active managers outperformed in both segments. However, in 2018, there was a notable reversal from positive to negative. Local currency debt was down -6.21 percent while hard currency was down -4.26 percent.1 As market sentiment turned, a large majority of active managers — 83 percent in local currency and 90 percent in hard currency — underperformed their relative index. In Q1 2020, after double-digit returns in 2019, emerging market bonds sold off sharply amid the COVID-19 crisis and active managers underperformed sharply.

EMD investors tend to appreciate that a bottom-up, fundamentally driven active approach should provide protection, yet our analysis does not support the claim that such approaches provide any meaningful downside mitigation.

This holds true in the hard currency universe where the diversified profile and absence of currency effects should create optimal conditions for active managers. We looked at five significant negative return events in recent years that were driven by individual or multiple countries in the EMBI-G Index or by broader macro events. In general, these events were driven by factors such as a sharply deteriorating economic outlook, political instability, debt restructuring, or a broad-based sell-off in risk assets. Some were perhaps easier to foresee, such as the Venezuela and Argentina restructurings, while others, such as Russia’s annexation of Crimea and the Taper Tantrum, were not. In any case, either active managers were unable to predict these developments effectively or certain behavioral biases impacted their ability to manage these events profitably. Active managers underperformed the index during each of these periods.

The median return compared to the JPM EMBI Global Diversified Index was -3.36 percent for the period, so the average underperformance wasn’t influenced by a couple of outliers. In the local currency debt space, active managers underperformed on average by -1.3 percent. The worst return lagged the GBI-EM Index by -5.08 percent, with the median underperforming by -1.46 percent.2 While average performance in local currency was better than in hard currency, only three managers among the 30 largest in Morningstar outperformed the GBI-EM Index after fees. The relatively better performance of local currency managers leads us to believe that this had something to do with liquidity, which was more challenging in hard currency than in local currency markets.

The volatile nature of the EMD sector is likely one of the key causes of active manager underperformance. Returns are often misaligned with fundamentals, as they are also heavily driven by investor sentiment, political risk and central bank actions; these can be difficult to predict and can often lead to binary outcomes. More specifically, active managers face different challenges in hard and local currency debt.

Challenges Faced by Active EMD Managers

In local currency debt, performance has two key drivers of return — the currency (FX) component and the rate component. Over the long term, our research shows that while rates are the key driver of returns, the FX component accounts for approximately 70 percent of the volatility. EM currencies are the main adjustment valve to reflect market sentiment, which means that making the right call, especially in times of heightened market volatility, is particularly difficult. Because EM currencies are priced against the US dollar (USD), active managers have to consider the likely direction of USD, which is notoriously difficult to predict and time. The performance of USD in 2020 provides a good case in point.

In Q1 2020, the dollar benefited from its “safe haven” status as the COVID-19 pandemic began to unfold. However, it subsequently weakened as the Federal Reserve announced unlimited quantitative easing (QE), a negative for the currency. Since then, USD fluctuated between positive and negative performance as these factors and others including US growth, the US presidential election, and changing risk sentiment drove its performance.

EM currencies, on the other hand, are driven by their own fundamentals, monetary policy, political backdrop, and flows. Predicting which of these factors will prevail is a key challenge for active managers. Unsurprisingly, active managers struggle to get it right on a consistent basis.

In hard currency debt, performance is often driven by the high yield issuers in the index, as investment grade issuers are typically more fairly priced and provide fewer opportunities for alpha generation. Importantly, within the high yield sub-index of the EMBI-G, positioning towards distressed issuers determines a manager’s performance versus the index. For example, making the right calls on events such as Argentina’s litigation with holdout creditors or Venezuela’s willingness and ability to meet its debt obligations have been key to active manager performance. While many of these countries represent only a small part of the index, they make a big difference in performance, due to their distressed nature, high yield, and volatile returns.

Breaking down the performance of the high yield sub-index of EMBI-G by rating category from highest (BB) to lowest (C) quality illustrates this point. The lowest quality bucket (C) of the EMBI-G index contains distressed issuers and bears a historically volatile performance profile.

Breakdown of the High Yield Sub-Index of the EMBI-G Index

March 31, 2013 – March 31, 2021, monthly

EMBI-G Div. High Yield Sub-Index

BB

B

C

Total Return (ann.)

4.51%

6.50%

4.01%

-2.08%

Volatility (ann.)

11.18%

8.27%

12.31%

25.95%

Sharpe Ratio

0.34

0.70

0.27

-0.11

Max Drawdown

-22.93%

-14.37%

-25.87%

-60.10%

Source: Bloomberg Barclays, JP Morgan, State Street Global Advisors, as of March 31, 2021. Historical returns for the time period March 31, 2013–March 31, 2021, monthly. Past performance is not a reliable indicator of future performance.

An index designed to avoid the lowest quality sectors of the hard currency EM debt markets may give investors an opportunity to generate more consistent returns with lower volatility. An example of this approach was taken in designing the benchmark of the SPDR® Bloomberg Barclays Emerging Markets USD Bond ETF (EMHC), where the index includes a ratings floor that excludes bonds with at least one rating of CCC- or lower. This custom Bloomberg Barclays Emerging USD Bond Core Index exhibits a modestly more favorable risk-adjusted return profile versus the JPM EMBI Global Diversified Index.

Bloomberg Barclays EM USD Core Index versus JPM EMBI Global Diversified Index

March 31, 2013 – March 31, 2021, monthly

Bloomberg Barclays EM USD Core Index

JPM EMBI Global Diversified Index

Difference

Total Return (ann.)

4.54%

4.45%

0.09%

Volatility (ann.)

8.05%

8.27%

-0.22%

Sharpe Ratio

0.47

0.45

0.02

Max Drawdown

-14.20%

-14.68%

0.48%

Source: Bloomberg Barclays, JP Morgan, State Street Global Advisors, as of March 31 2021. Historical returns for the time-period March 31 2013–March 31 2021, monthly. Past performance is not a reliable indicator of future performance.

The high cost of replication and market volatility and inefficiency were traditionally seen as the main obstacles to index strategies in the EMD space. Although these concerns initially appeared valid, indexing techniques have advanced from simply buying all the constituents of the benchmark. There are a variety of practical steps that experienced EMD index managers can take today to deliver beta.

The cost of replication is no longer prohibitive. Trading costs for EM hard currency have decreased and the cost for local-currency-denominated securities is a fraction of that. In addition, experienced and highly specialized EMD trading desks and portfolio managers (PMs) work to keep portfolio implementation costs very low.

Index turnover directly affects returns via rebalancing costs, and EMD indices typically experience high levels of turnover compared to other fixed-income benchmarks. Experienced PMs are able to minimize turnover by proactively anticipating index changes, gaining exposure through primary market placements and working with traders to access liquidity pools with both well-known investment banks and local brokers. Examples of this include using the primary market to access illiquid markets prior to their inclusion in the index, managing risk through the forward or non-deliverable forward market, and ultimately delivering benchmark returns through a thoughtful, but risk-controlled, investment process.

One additional and important aspect of local currency markets is the existence of both withholding and capital gains taxes, which can be a significant drag on performance if not managed carefully. A sophisticated investment management process that understands the risk-reward trade-offs between fully replicating the benchmark and alternative positions or proxies can minimize this tax drag without compromising the tight risk tolerances relative to the benchmark.

Our EMD Capabilities

State Street Global Advisors has been managing indexed EMD strategies for over a decade and holds nearly $32 billion in assets under management across local currency and hard currency debt, sovereigns, and corporates.3 This investment expertise is evident in our consistent and efficient delivery of benchmark returns across our indexed EMD strategies and funds.

Our indexed EMD strategies are far from passive when it comes to portfolio construction and security selection. Our experienced PMs will consider market dynamics, liquidity, and other factors when choosing securities in order to gain the required underlying exposure in the most effective and performance-enhancing way.

Authors

Lyubka Dushanova
Portfolio Specialist, Emerging Market Debt

David Furey
Head of Fixed Income Portfolio Strategists, EMEA
 
with contributions from
 
Marcel Benjamin
Vice President, SPDR Fixed Income Group
 
Orhan Imer
Senior Portfolio Manager, Fixed Income Beta Solutions Group
 
Arkady Ho
Portfolio Specialist, Global Fixed Income