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Market View

Our experts outline some key considerations for investors weighing the use of actively managed strategies in the emerging-market sovereign debt space.

 

In Brief

  • Country selection is vitally important in an emerging market portfolio, in our opinion, particularly when considering how much exposure to allocate to one country or another.
  • While fundamental research is a foundational tenet of emerging markets investing, connectivity with various country officials and multi-lateral institutions also may be a key factor.
  • Passive emerging markets strategies can be significantly less efficient than most investors would prefer.

 

Investing in emerging markets (EM) is still a relatively new phenomenon, considering that institutional investing in such countries began just over three decades ago, when the World Bank encouraged more investment in the capital markets of underdeveloped nations. The category got a big lift when J.P. Morgan developed the J.P. Morgan Emerging Markets Bond Index in 1998, which created a crucial benchmark for active and passive strategies focused on EM sovereign (i.e., government-issued) debt. Since that time, international markets have seen the creation of mutual funds and exchange-traded funds (ETFs), among other investment vehicles that enabled a variety of investors to add this exposure to their portfolios. The options may be plenty, but we believe there are three important considerations for investors when deciding between passive and active strategies.

1. The importance of country selection in an EM portfolio
While large emerging countries like China, India, and Brazil garner the most attention in the media, the EM investable universe is much broader; the J.P. Morgan Emerging Markets Bond Index includes over 70 countries. The efficiency of research across all of those sovereign issuers (especially smaller ones like Angola or the Dominican Republic) is limited, thus presenting opportunities to exploit market inefficiencies. Chart 1 illustrates the critical importance of correct country selection and vast potential for active alpha generation.

 

Table 1. Country Selection Has Been Crucial for EM Sovereign Bond Returns
Dispersion of returns by country grouping (as defined), 2014–2018

Source: Bloomberg. Data as of December 31, 2018. “Top country” and “bottom country” refers to best and worst performing country, respectively, within J.P. Morgan Emerging Markets Bond Index Global Diversified Index for the referenced time period. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.
Past performance is not a reliable indicator or guarantee of future results.

 

2. Human connectivity is key to investment strategy in a technology-focused world.
Fundamental research plays an extremely important role in emerging market country selection, and active managers devote significant resources toward that end. To effectively assess the investment merits of EM issuers, we believe an investing team’s ability to travel to EM countries in order to establish deep relationships with local banks, policy makers and country experts is essential to research capabilities and the generation of active investment concepts. In addition, investment professionals’ relationships with far-reaching, multi-lateral institutions such as the International Monetary Fund or the World Bank can leverage the knowledge, and connectivity, and access to financial and technical data these bodies can provide.

 

Chart 1. With 189 Member Countries, the IMF Is a Critical Resource for EM Managers
International Monetary Fund member countries as of December 31, 2018

Source: International Monetary Fund

 

3. Index-mirroring passive EM strategies are not well positioned to avoid risk.
The political and economic complexities of emerging markets can make the investment strategy of simply following an index less effective than investors would prefer. Chart 2 compares the alpha generation of two ETFs versus each fund’s prospectus benchmark, illustrating underperformance over three-, five and 10-year periods. As active managers, we seek to utilize our robust global investment process in the pursuit of outperformance. From a macro view, we seek to evaluate global risk appetite and global capital flows to calibrate overall risk of the portfolio. We also use quantitative models and comprehensive risk modeling.

 

Chart 2. Major Passive Emerging Market Bond ETFs Underperform Benchmarks
Comparison of alpha generated by select ETFs versus their prospectus benchmarks for three-, five-, and 10-year periods

Source: Morningstar. Annualized data is of 03/31/2019. The alpha generated by the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) is being compared to its prospectus benchmark, the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Core Total Return USD. The alpha generated by the Invesco Emerging Markets Sovereign Debt ETF (PCY) is being compared to its prospectus benchmark, the DB Emerging Market U.S. Balanced Liquid Total Return USD. Exchange-traded funds shown are net of fees. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

In addition, as active managers we seek to avoid bonds of sovereign issuers where our estimates of probability of default are rising. In contrast, a passive rules-based ETF will seek to mimic the index even if default is imminent. Venezuela’s recent experience provides a good example. As its finances began to weaken in mid-2014 on the back of significant declines in oil prices, the country continued to issue more and more debt at higher coupon rates. At the peak, Venezuela made up 13% of the J.P. Morgan Emerging Market Bond Index Global (EMBIG), and now only about 1% remains in the benchmark. An investor following a passive strategy that included those bonds would be accepting 70% loss of value on those securities. We illustrate this in Chart 3, which shows Venezuela’s Global 2027 Bonds trading at par and now trading at 30 cents.

 

Chart 3. The Plunge in Venezuelan Sovereign Debt Weighed on Many Passive EM Portfolios
Prices for Venezuela 9.25% USD 2027 Global Bonds, January 1, 2009–April 16, 2019

Source: Bloomberg. Data as of April 19, 2019.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

Therefore, careful selection and close monitoring of country exposure in geopolitically complex environments are both a core part of an active investment strategy within emerging markets. Avoiding these asymmetric movements could be instrumental in enhancing returns on emerging market debt.

Summing Up: How AM Can Work in EM
As active managers in emerging markets fixed income, we highlight country selection, in-depth research, and having the ability to actively make adjustments to risk exposure. Given the sensitivity of emerging markets to worldwide economic trends (such as global growth and rates), it is important as a starting point to develop a view on broader risk appetite and credit cycles for EM sovereigns. In addition, the ability to interface with international banks and government officials provides a deeper understanding of risks; in that regard, local visits by the research team and relationships with local experts are critical. It is our belief that an optimal investment strategy in emerging markets should always encompass an active management consideration.

 

Glossary

The DB Emerging Market U.S. Balanced Liquid Total Return USD Dollar Index tracks the potential returns of a theoretical portfolio of liquid emerging market U.S. dollar-denominated government bonds issued by approximately 22 emerging-market countries. The countries in the Index are selected annually pursuant to a proprietary index methodology and the membership list is rebalanced quarterly.

J.P. Morgan Emerging Markets Bond Index (EMBI) is a benchmark index that measures the total return performance of emerging market government bonds, not issued in local currency. To be part of the index, the government bonds must meet specific liquidity and structural conditions.

International Monetary Fund (IMF) is an organization that “promotes international financial stability and monetary cooperation. It also facilitates international trade, promotes employment and sustainable economic growth, and helps to reduce global poverty. The IMF is governed by and accountable to its 189 member countries.” (via IMF.org)

J.P. Morgan Emerging Market Bond Index Global (EMBI Global) is a benchmark index that measures the total return performance of international government bonds that are issued by emerging market countries, not issued in local currency, and meet specific liquidity and structural conditions. EMBI Global includes USD Brady bonds, loans and Eurobonds with a face value of $500 million or more.

This article is being provided for informational purposes only and is intended to illustrate certain information analyzed during the research process. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. Investing in international denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.

No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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