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Forward-Looking Investing

Ease EMFX Volatility with an Aggregate Strategy

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Written by: Fran Rodilosso

The emerging markets sell-off has continued in recent weeks, as the U.S. dollar remains strong amid domestic economic data that supports a case for higher U.S. interest rates. Many emerging markets local currencies have been severely impacted, particularly those of more vulnerable countries and where political risk is rising.

While we believe that value can now be found in various aspects of the emerging markets debt universe and that the local currency space may become the most attractive opportunity of all, the spike in volatility may prevent certain investors from adding to or initiating allocations. For these investors, we believe that a blended approach combining emerging markets sovereign and corporate bonds across hard and local currencies may present an attractive alternative.

Although an all hard currency allocation can mean avoiding local exposure altogether, hard currency sovereign debt has performed similarly to local sovereign bonds year-to-date. Allocating to the entire investable opportunity set means approximately 64% exposure to hard currency and 36% exposure to local currency bonds. This diversification may potentially help reduce the volatility and drawdowns associated with local currencies, while offering exposure to their higher potential yields, lower historical correlation to the interest rates of developed markets, and the potential to benefit from currency appreciation. Further, the performance of emerging markets corporate bonds and sovereign bonds can vary greatly in a given year, in part due to a diverse geographic makeup and a broad sector mix that can respond differently to various macroeconomic environments.

Based on index data over the past several years, an aggregated approach to investing in emerging markets has generated significantly lower volatility compared to a local currency exposure, which saw significant drawdowns in 2014 and 2015. On the other hand, the aggregated approach benefitted from its local currency allocation in 2017, outperforming both hard currency emerging markets sovereign and corporate bonds. Year-to-date, the aggregate index has benefitted from an approximately 42% exposure to corporate bonds, which have outperformed hard currency sovereign bonds, albeit with moderately negative returns.1

The benefits of an emerging markets aggregate bond exposure may explain the increasing flows into these strategies. According to J.P. Morgan, strategies which blend corporate and sovereign exposure took in approximately $35 billion in 2017, a similar level to sovereign focused emerging markets strategies. Longer term, flows have gradually increased and cumulatively have taken in the same amount as local currency strategies since late 2009.2

Related: It’s Now or Never for Energy Stocks

We believe that a passive blended strategy warrants attention, given the index’s track record relative to actively managed peers, as well as the low cost and transparent nature of index-based strategies. Although diversification and tradability are fundamental to virtually any passive strategy, we believe these elements should be given particular emphasis when investing in emerging markets debt due to the potential concentration risk of many active strategies and the importance of maintaining liquidity and low transaction costs, particularly in stressed market environments.

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