We strongly believe that the traditional benchmark-led approach to investing in emerging market debt can be far from optimal. There are two major flaws in being overly wedded to an off -the-shelf benchmark:
1. There are embedded characteristics, or betas, that may not necessarily be desirable. In particular, there is significant USD duration exposure associated with a hard currency1 strategy, typically managed relative to the EMBIG-D,2 while EMFX exposure is a major component of a local currency strategy, typically managed relative to the GBI-EMGD.3 It is often the case that an investor already has plenty of USD duration from other bond portfolios and EMFX exposure from emerging market equities, yet simply accepts these characteristics as part of an emerging debt investment because they are embedded in the benchmark. (A blended benchmark is somewhere “in between” from a beta standpoint, with lower durations than EMBIG-D, and EMFX exposure determined by the extent of GBIEMGD’s presence in the blended benchmark.)
2. If a manager’s opportunity set is constrained by their benchmark, potential alpha opportunities may be de-emphasized, or even ignored completely. For example, there can be limits on the amount of “off benchmark” holdings and exposures that a manager may take relative to their EMBIG-D, GBI-EMGD, or CEMBIB-D4 benchmark, regardless of how similar such exposures may be in practice relative to his stated benchmark. In theory, blended benchmarks relax this constraint, expanding alpha opportunities.5
We are increasingly having conversations with clients that are seeking to unlock the exciting return opportunities in emerging debt while being much more discerning about embedded betas. A single benchmark, or indeed a blend of benchmarks, can be determined to allow for whatever USD duration and EMFX exposure best suits the investor’s overall objective. Lately, with more emerging countries entering debt distress and/or default, the “quality” axis is also a topic of interest, with some clients preferring the stability of higher-quality credits, and others interested in leveraging our considerable skill in sovereign debt workouts among distressed/defaulted issuers (some of which are “frontier” markets). To us, these are the “big” asset allocation levers, although blended benchmarks are not the only way to achieve them given how trivial it is to target duration, USD/EMFX exposure, and/or quality in any setting. An obvious extension is to remove the beta associated with emerging debt benchmarks completely, and freely use the full combination of alpha sources to target a total return over cash. Indeed, whatever overarching objective is set, the ability to use all alpha sources coupled with a liberal approach to tracking error should ensure the best outcome. We already use this approach in the management of our existing long-only strategies.