Managing for asymmetrical risk in EM local debt - Planning for a smoother ride

The complex character and potential volatility of locally denominated debt in emerging markets calls for a different look at risk management and manager skill. Our approach aims to participate in the potential upside while reducing downside risks.

Minimising downside potential

When it comes to investing in emerging market (EM) local debt, we seek to maximise returns from market exposure to potential attractive yield and income opportunities that go hand in hand with the relatively higher risks of this asset class.

At the same time, we believe manager skill can help minimise downside potential, even if it means missing out on certain trades that could result in above-market returns.

Locally denominated debt securities in emerging markets expose investors to a variety of risks, driven by factors, such as: foreign exchange, credit quality, interest rates, macroeconomic conditions, and regional politics.

This unique combination of risks, in our view, warrants special emphasis on seeking to limit the downside potential - one that requires manager skill - while aiming to wring value from market exposure to attractive yields and income.

We believe a portfolio’s tracking error is an inadequate measure of volatility because it gives equal treatment to the positive and negative differences between a portfolio and its benchmark.

Aiming for a smoother ride

Our proposed strategy for affording investors a smoother ride throughout emerging market cycles is to incorporate an element of capital loss mitigation during downturns:

• Maintaining a low tracking error and high volatility in ‘risk-on’ periods, i.e. staying close to the benchmark’s volatility when we believe market conditions are favourable.
• Maintaining a high tracking error and low volatility in ‘risk-off’ periods i.e. significantly reducing the portfolio’s volatility relative to the benchmark when we believe market conditions may deteriorate and become risky.
  

Multi-part framework

We have designed a multi-part framework for riding out emerging market gyrations and seeking  above-market annualised returns over the long haul:

1. Analysis: Conduct a global macro analysis of emerging and developed markets – as well as the linkages between them. We believe that no market or region can be viewed in complete isolation from any external factors that are affecting it, e.g. trade or international relations.
2. Risk budget: Determine a risk budget – the overall risk we wish to take, as well as the risk relative to the benchmark.
3. Country-level risk: Once an overarching risk framework is established, we drill down to the country level. We determine the appropriate levels of risk, as well as the asset type– interest rates, foreign exchange and/or credit – through which to invest.
4. Choosing securities: Seek to identify country-specific opportunities through one or more asset types. We will take into account the risk/reward profiles they represent and security fundamentals.

Once we identify specific opportunities, we conduct bottom-up security selection, which aligns with our top-down risk budget.

In our view, it is the macro-driven risk budget that dictates the final shape of the portfolio and security-level decision making must fit into this. Not the other way around.

Conclusion

The risk/reward nature of locally denominated debt emerging markets can be highly idiosyncratic. This is the result of a complex interplay of multiple factors, including: foreign exchange, credit quality, interest rates, macroeconomic conditions, and regional politics.

We believe investing in them requires a more nuanced view of risk management and fund manager skill, with the end goal of providing a smoother investment experience in potentially volatile emerging markets.