According to recent research by Bfinance, there has been a rapid increase in the number of blended emerging market debt strategies.
The number of these funds, which combine both hard and local currency-denominated debt, has increased to more than 60 in 2017, from only 20 in 2009.
Bfinance’s findings are backed up by recent data from EPFR. Abhishek Kumar, lead investment manager at State Street Global Advisors, says: “Last year’s total flows into emerging market debt were around $112.8bn, of which around $41.5bn was into blended strategies.” This is a material increase from the previous year: it was $12.7bn in 2016.
Mathias Neidert, head of public markets investment advisory at Bfinance, says: “The increased popularity of blended strategies is linked to the rise in popularity of multi-asset credit strategies as they have similar investment philosophies.”
Increased demand for these funds also reflects institutional investors’ greater familiarity with emerging market debt. Each EMD asset class – hard currency sovereign debt, local currency sovereign debt, hard currency corporate debt as well as local interest rates and currencies – has distinct investment characteristics.
For example, hard currency sovereign debt returns come principally from the bond yields. Mr Kumar says: “But the second largest driver of returns is its exposure to US interest rates because these instruments tend to have long duration.”
In contrast, local currency returns are driven by yield.
Mr Kumar says: “While relative currency fluctuations cause volatility over the short term, over the longer term this disappears.”
In theory, an institutional investor could simply appoint a number of fund managers, each specialising in a particular sub-asset class.
But most investors have abandoned this static approach because of periods of underperformance.
Not only can short-term currency fluctuations create volatility for local currency-denominated debt but there are also medium-term cycles when one sub-asset class will outperform another.
David Griffiths, emerging markets debt portfolio manager at Stone Harbor, says: “There are, for example, three- to five-year periods when local currency outperforms hard currency.” Then the cycle will switch and dollar-denominated debt will generate better returns for a similar period.
Investors were particularly negatively affected by these trends between 2013 and 2015, when local currency underperformed dollar-denominated after the taper tantrum.
Mr Neidert says: “They realised they lacked the expertise needed to anticipate this market correction and make the necessary adjustments to their portfolio.”
This regret has been one of the driving forces behind the popularity of blended strategies. Mr Kumar says: “It is easier for a scheme to choose a blended manager and let them allocate between hard and local currencies.”
Mr Neidert adds: “Investors want a manager with expertise in emerging market debt and who is nimble enough to make the necessary tactical changes within the different sub-segments.”
But investors need to have the right expectations of a blended emerging market debt manager.
Mr Neidert says: “Most investment managers are building their portfolios from the bottom up, rather than from the top down.”
In other words, most managers are not acting as a ‘super allocator’: they are not deciding how the portfolio should be divided between hard and local currency.
Mr Neidert says: “Instead, managers make a decision about the economic outlook for each country and which assets they prefer within each country.” The overall exposure of the portfolio to hard or local currency is established by these aggregated individual allocations.
Even though this approach does not entirely match the aims of institutional investors, it is a rational way to build a portfolio. There are a greater number of countries in the emerging market debt universe than the developed market. This makes asset selection more important because there can be a wide dispersion in performance.
There is also wide dispersion between the best and worst-performing foreign exchanges. This gives managers the ability to boost the performance of their fund by selecting between different local currencies, even for those managers benchmarked to an index with a 50:50 exposure to hard and local.
Those same benchmarked managers can bolster the performance of the hard currency part of the portfolio by selecting the right assets.
Mr Neidert says: “While many investors select a blended fund manager because they are looking for someone to help them to allocate tactically between hard and local currency, even those managers who do not seem that dynamic can create a lot of alpha.”
For some pension schemes, however, this bottom-up approach might not work. Mr Neidert says: “Some schemes might need a ‘super allocator’: one who actively makes a decision about how much exposure to have to hard and local currencies.”
For example, a scheme might want a super allocator if they have existing investments in emerging market debt with a hard currency and a local currency manager.
Mr Neidert says: “They might feel the need help to decide how to allocate between these two asset classes.”
In this scenario, a third manager who provides some input on how to manage the static allocation within the portfolio. Mr Neidert says: “This would add another tool to those standalone investments.”
Some managers do include a top-down approach along with their bottom-up bond selections. Mr Griffiths says: “We double check our portfolio reflects our forecasts for the relative performance of hard versus local currency.”
If the bottom-up approach is mismatched with the relative performance for hard versus local currency, it will be changed to better match that forecast, he adds.
Other schemes are not looking for a super allocator but a ‘best ideas’ fund. This is typically schemes that use passive solutions for their EMD exposure. Mr Griffiths says: “This leaves them with risk budget which can be used for an absolute return-style concentrated portfolio.”
For other schemes, however, another benefit of outsourcing the asset allocation to manager has been risk reduction.
Som Bhattacharya, product specialist for EM blended strategies at BlueBay Asset Management, says: “Many of these strategies have a built-in element of downside protection.” This is achieved by using macro- or single-country hedges along with their bottom-up stock picks.
But this is not the case with every strategy: some will be deliberating targeting high performance, so schemes should investigate carefully if they want this included in their investment, he adds.
The diversity of management styles within the blended strategy is significant. Schemes need to carefully identify their own investment goals to find the fund that bests fits their investment goals.