Market commentators may have painted a negative picture of emerging-market debt (EMD) in recent years, but the performance of the asset class has been remarkably resilient. Since the Lehman crisis in 2008, EMD has posted positive returns every year except in 2013. Not even the commodities crash in 2015 could derail the unswerving performance.
EM economies continue to develop for the better. The average credit rating in the local currency index is now investment grade. Debt levels are also low compared to developed-market nations, with debt-to-gross domestic product (GDP) of around 40-50% versus 100%, respectively. With meager returns on offer from cash and developed-market government bonds, EMD is an asset class that merits close attention.
But should you invest actively or passively in EMD? The “active or passive” debate is hardly new, and yet it’s still fiercely contested. Both strategies boast their own advantages. But when it comes to EMD, an increasingly complex and diverse market, the case for active management has arguably never been so strong.
1. It’s not all about the cost
Investors have become increasingly focused on fund fee structures in recent years. Typically, an actively managed fund will incur higher fees than one that is passively managed, and this additional cost acts as a drag on performance, hence the increasing popularity of the passive route.
But this may be a false economy. While exchange-traded funds (ETF) and index trackers generally have lower fees, investors need to question whether they are really worth it. Across the EMD universe, it can often be a case of “you get what you pay for,” and after-fee returns are what really matter.
While ETFs and index trackers generally have lower fees, investors need to question whether they are really worth it.
Not all EMD ETFs are low-cost either. Prospective buyers must look carefully at the expense ratio, with some new products charging over 1% in fees. This is not far off what many active managers charge for their experience, expertise and intelligence. It’s also considerably above the traditional market index ETF charge of around 0.2%.
2. ETFs often invest in only a fraction of the EMD universe
Most EMD ETFs funds miss out on a huge proportion of investable assets. One of the largest funds invests only in U.S. dollar-denominated sovereign debt, meaning it misses out on nearly two-thirds of the sector’s investible universe. Another is unable to invest in roughly 45% of its benchmark as it excludes quasi-Sovereigns as well as the majority of country issuers within the index. These two funds – which, between them, control approximately 75% of the assets within EMD ETFs – offer no exposure to EM corporates or local currency debt, two sub-components of EMD that are expected to do well in the near term. This does not mean that either fund will perform poorly, but it does severely limit investors’ exposure to potentially lucrative segments of EMD.
3. A question of safety
There’s a perception that the lower cost of passive strategies somehow translates into lower risk. If anything, ETFs and index trackers are more vulnerable to market volatility: they are forced buyers when the market is rising, and forced sellers when it’s declining. Debt issued by EM governments and companies can often be harder to buy and sell, and losses can intensify when the market falls. It’s also worth noting that EMD ETF performance in a down market is relatively untested.
Conversely, active managers can prepare for such events. They can raise cash levels and/or manage the duration of the portfolio to provide a cushion.
4. Understanding benchmarks
Benchmarks are typically constructed using a market-cap or issuer-focused method. This skews investors to the most indebted governments and companies as they issue more bonds. Of the 65 country issuers in the JP Morgan Emerging Markets Bond Index Global, the top five issuers account for over 40% of the index, and the top ten make up 60%. Passive funds have no choice but to replicate the index, so there is a large amount of risk concentrated in a small number of issuers.
EMD has become an increasingly complex and diverse market that we believe requires an active approach. There is no one-size-fits-all approach to investing in this market, and certainly no “silver bullet.”
Flows into EMD ETFs have grown rapidly in recent years. During 2016, the area attracted inflows of $11.1 billion. Recent data from BlackRock revealed that, in the three months to the end of March, there were further inflows totaling $6.2 billon. Looking ahead, it is likely that ETFs and index trackers will continue to eat into active managers’ market share. But investors should recognize their limitations, which are likely to be exposed when volatility returns.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.