Investing in emerging markets (EMs) typically offers investors the chance to benefit from rapid growth and potentially high returns. Compared to developed markets, EMs are less established and hence more volatile. EMs also tend to benefit from high population growth and technology developments while having decent valuations. EMs are a unique investment opportunity because they offer a more balanced risk to reward profile
Global investment manager Capital Group posits that an allocation to emerging market debt (EMD) can offer investors a range of potential benefits in the context of its broader portfolios — not least the asset class’s low correlation with other fixed income sub-asset classes. The potential growth dynamics and strengthening economic fundamentals that many EM countries present are attractive to investors seeking growth, income and diversification.
“To build and evolve this approach effectively, we start with a stable foundation, leveraging the extensive experience of our EMD portfolio management team at Capital Group, where the average tenure is 30 years,” explains Jeik Sohn, head of client group, Singapore and Southeast Asia, at Capital Group.
“This stability enables us to incorporate new skill sets and diverse perspectives as markets evolve, resulting in a wealth of ideas essential for a successful strategy,” he adds.
Such a stable foundation has allowed Capital Group to forge a long-term strategic approach to EMD investing with its EMD capabilities. Based on a strategy with a long-term track record of consistent returns*, Capital Group Emerging Markets Debt Fund (LUX) follows the same investment approach and is managed by the same experienced team. It is this consistency of approach that has allowed the fund to win the accolade of one of the Best Performing Fixed Income Funds under the Global Broad Category of over US$1 billion ($1.36 billion) at the Best Funds Award 2024, hosted by The Edge Singapore.
“This recognition is a testament to Capital Group’s long-standing efforts in the region, striving to improve lives through successful investing. We have had a presence in Asia for over 40 years now and, as always, remain focused on the long term in our approach,” reflects Sohn.
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The fund seeks to provide a high level of long-term total return, of which current income is a significant component, by investing in emerging market government and corporate bonds, denominated in various currencies of issuers in eligible investment countries.
As at March 31, the fund size is about EUR1.09 billion ($1.58 billion), while its base currency is in USD. The fund’s rating breakdown consists mainly (83.2%) of government and agency issuances. Its top five holdings are the Brazil Government (BB-rated) at 6.8%, Indonesia Government (BBB-rated) at 5.9%, Mexico Government (BBB-rated) at 5.8%, South Africa Government (BB-rated) at 5.6% and Poland Government (A-rated) at 4.3%.
Invested capital is at risk; the fund aims to achieve a positive return over the long term although there is no guarantee this will be achieved over that or any time period.
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Unwavering commitment
According to Sohn, an active approach offers a more deliberate allocation of capital and can help mitigate some of the unintended consequences of index construction methodologies. The starting point for the construction of an EMD index remains the level of sovereign debt outstanding (and so the more debt that a country has, the greater its weight in the index) and as index composition evolves and is rebalanced, the exposure provided by a passive strategy will shift accordingly. A passive investor, therefore, has limited control over the composition of exposure taken.
As Capital Group celebrated its 50th anniversary of investing in fixed income markets last year, Sohn recalls the company navigating several crisis and inflationary environments. Now the fourth-largest active fixed income asset manager in the world, its commitment to long-term investing has never wavered.
In the past five decades, the fixed income asset class has grown beyond recognition. Now making up US$6.8 trillion in assets, EMD was yet to exist as an asset class for another 20 years.
In the mid-1990s, EMD was a relatively narrow asset class consisting of just 12 to 15 countries issuing hard currency debts. Little changed until the early 2000s when local currency debts and corporate bonds were introduced.
The asset class has gradually expanded to encompass almost 70 countries, issuing a broader range of debt instruments. In addition, some countries have made significant progress in establishing local yield curves, which can reduce their vulnerability to fluctuations in the US dollar and enhance stability.
The fast-paced evolution of EMD as an asset class necessitates an investment approach that can adapt swiftly. From a research perspective, it was very much a boots-on-the-ground approach for Capital Group to begin with, which contrasts with the relative abundance and quality of data that is now available. This has meant that its fixed income team has had to adapt their approach as the asset class becomes more similar to the wider fixed income market, while still maintaining a necessary nuance to the investment process.
Emerging growth
“The case for a strategic allocation to local currency EMD remains strong. While passive allocation can be a relatively low-cost way to gain exposure to this market, we believe active management can offer investors a more effective way to navigate such dynamic market conditions,” says Sohn.
To fully understand each market and assess which countries to allocate to and which to avoid, it is essential to conduct in-depth, fundamental research into individual countries’ rates and currencies, framed in the context of the global macro environment. As the opportunity set has developed, deep understanding of market technical and trading strategies can further complement fundamental research to enable successful market execution, and can have a significant impact on return. Similarly, robust risk management is essential.
In most of the core EM economies, inflation is expected to decline throughout 2024, allowing policy rates to come down and providing a supportive backdrop for local currency debt. That said, caution is warranted as EMs may still have to contend with weak global growth, ongoing geopolitical uncertainty and a busy global election year. Therefore, the enhanced ability to manage volatility offered by active strategies will assume ever greater importance.
An allocation to passive or smart beta strategies can provide an effective and low-cost way to access the broad market. However, these approaches can lead to exposure biased towards countries that are increasing their level of indebtedness and can also restrict opportunities to capture relative value through market movement.
“We believe an active investment approach that is aware of the benchmark but not beholden to it, and draws on extensive research with disciplined risk control, offers investors the greatest opportunity to generate strong risk-adjusted returns through shifting volatility regimes,” says Sohn.
Perhaps the most important point is that adopting an active strategy to gain access to local currency EMD provides investors with the broadest possible investable universe.
Certain benchmarks restrict the opportunity set available due to construction methodologies and constraints; this is logical, and indeed serves to facilitate active management by providing a useful reference point for risk management. The presence of widely adopted benchmarks also enables the comparison of results across managers in support of manager selection.
However, a large proportion of the investable universe — close to 90% — is excluded as a result. This can be to the detriment of passive investors, as they are (perhaps unintentionally) restricted to exposure to only a limited subset of the local currency debt market, which has been pre-selected by the benchmark providers.
An expanded opportunity set therefore creates a more diversified asset class and could offer active investors the potential for increased and more varied sources of alpha.
*As at March 31, 2024. Data based on Capital Group Emerging Markets Debt (Blend) Composite (inception: February 2006), before fees and expenses and includes all fee-paying, discretionary portfolios managed according to Emerging Markets Debt (Blend) strategy, in which Capital Group Emerging Markets Debt Fund (LUX) (inception July 2007) is invested
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