US Treasury markets may have been shaken by the pace of the sell-off in the 10-year section in June 2007, but in emerging markets, the talk was of the speed with which asset prices recovered from the initial shock. Even currencies that suffered heavily in the May 2006 rout, such as the Turkish lira and Colombian peso, rebounded rapidly during the jitters just over a year later, while spreads on Global and Eurobonds widened only marginally.
Leading investors have theorized about the increasing maturity of emerging markets for at least two years, but this was perhaps the first concrete demonstration of the theory under stress-test conditions. The combination of greater resilience across emerging markets alongside tighter yields has encouraged institutional investors such as pension funds and insurance firms, who would once have baulked at the risks, to take on exposure to emerging market funds.
It has also changed the way that fund managers themselves are approaching the asset class. Ramin Toloui, portfolio manager for the world’s largest emerging market bond investor, PIMCO, told a conference in London recently that asset selection was replacing country selection as the source of relative outperformance.
“It’s not enough any more just to be long Brazil or long Russia. Hard currency or local currency, what part of the curve you are in, whether you play the market through T-bonds or swaps, the tax implications of onshore or offshore settlement, these are the things we have to look at now,” said Toloui.
New instruments and strategies
This perspective is reinforced by a wide-ranging recent survey conducted by Standard & Poor’s among funds with total assets of $500 billion under management. Of all recipients, 84% said they expected the use of derivatives in emerging markets to grow over the coming year, while 63% of fixed income investors said that the credit derivatives market was becoming a more attractive area to express opinions on emerging market credit trends.
A wave of new products is hitting the market to target demand for more sophisticated investment methods. HSBC recently launched the New World Income fund, an emerging market debt absolute return fund, with an objective of Libor plus 5% unconstrained by the weightings of traditional EM debt indices, and exposure to external and local debt (plus up to 10% EM equity). Peter Marber, the fund’s manager, said it would use derivatives both to control risks and to express investment views, while its selection approach would include not only macroeconomic research, but also fundamental analysis of the instruments themselves.
Emerging currencies: a single asset class?
Meanwhile, Banque AIG, the financial products wing of the US insurance group, launched in March 2007 a series of customizable emerging markets foreign exchange indices (EMFXI), to allow money managers to gain passive exposure to a broad range of emerging market currencies. For transparency, AIG kept the selection criteria simple: all the currencies in the master index are equally weighted, and emerging markets are defined as economies with a GDP per capita no more than half that of the US, and a sovereign rating below Aa1 (Moody’s). This means that the Singapore dollar, which comprises a significant part of JP Morgan’s weighted money market benchmark, the Emerging Local Markets Index (ELMI), is excluded on both counts from the EMFXI.
The full index consists of the 19 most liquid tradable EM currencies, with rolling underlying deliverable or non-deliverable forward positions allowing settlement of the index – the Thai baht was dropped in 2006 after the introduction of capital controls in Thailand.
Stephen Gilmore, emerging market currency strategist at Banque AIG, and one of the architects of the EMFXI, points to the growing correlation of returns on emerging market currencies as a further sign that investors are beginning to play an increasingly cohesive asset class through distinct instruments.
“When I started out in EM currencies 10 years ago, I would have been following individual news and data releases from each country. Now I’m looking at the asset class as a whole,” he tells Emerging Markets.
Moreover, Gilmore kept an open mind about what the most receptive audience for the product would be, and has so far been impressed by the breadth of appeal.
“We wanted to know who the natural user would be: an emerging market fixed income manager, or a pension fund, or someone looking for access to alpha. In fact, it seems to appeal to all of these, and we have had interest from product providers looking at listing index funds, or even developing structured instruments such as constant proportion portfolio insurance,” says Gilmore.
Returns backtested for 10 years were relatively resilient to events such as the maxi-devaluations in Turkey and Argentina in 2001. This is partly because the risk premium on EM yields contributes to excess return alongside the exchange rate moves. In addition, exposure is diversified between more volatile units such as the Turkish lira and Argentine peso on the one hand, and funding currencies such as the Taiwan dollar or Czech koruna that benefit from higher risk aversion on the other hand.
Long-term appreciating trend
Gilmore is confident that the long-term trend toward overall emerging market exchange rate appreciation against the majors is set to continue.
“Economic growth is stronger, budget balances are healthier, many emerging markets are running current account surpluses, and even those that are not are self-insuring through the buildup of foreign exchange reserves,” argues Gilmore.
Added to that, he believes the full implications for the dollar of the growing trend among emerging markets in Asia and the Gulf to consider diversifying their vast foreign exchange reserves through sovereign wealth management bodies have yet to be felt.
Gilmore thinks alternative asset managers may already have spotted the potential of broad-based exposure to emerging market forex: the performance of the index for the three most recent years shows a growing correlation with hedge fund returns.
“But of course, investing directly in the EMFXI means you don’t pay hedge fund management fees, and you can exit more easily, and the asset allocation is more transparent, and so on,” he adds with a smile.
In line with the growing maturity of emerging market economies, Gilmore expects the EMFXI to evolve as the more developed countries cease to be eligible for inclusion. The Slovak koruna is likely to be the first component to exit once Slovakia joins the euro, making room for another currency that is less liquid at present, such as the Romanian leu or Vietnam dong.
However, it is left to Jon Cleary, who in 2006 created Focus Capital, the first dedicated emerging market multi-asset fund of funds, to sound a note of caution. He agrees with the overall positive macroeconomic and structural perspective for emerging markets, but warns that a more mature asset class is not always being matched by more sophisticated asset management.
“Investors, experienced or not, have been chasing assets in their search for yields. Local markets are one of the main areas that have grown, and that is a concern for us. At the end of the day, a local currency bond has a residual trade versus the dollar in some form. We’ve found very few people who can predict accurately where the dollar is going to be, and likewise where the local currency is going to be, and therefore necessarily make a positive return over time,” Cleary warns.