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1 White Paper Emerging Market s An Asset Class Primer DiMeo Schneider & Associates, L.L.C. By: Bryce J. Anderson, CFA DECEMBER 2011 Emerging Market bonds are a growing sub-sector of the foreign debt market. Governments and businesses in Latin America, Eastern Europe, and Asia (ex-japan) issue debt to finance fiscal deficits, infrastructure projects and business growth, as well as to sterilize large capital inflows and avoid intermediation uniquely in banks. Currently accounting for less than 5 percent of the world s bond issuance, emerging market countries are growing faster than the developed world. Their capital markets are also increasing in size. While emerging market bonds may have greater political risks, the countries lower debt levels, lower trade deficits (often surpluses), higher savings rates, and younger population arguably put them in better fiscal positions than many of their developed market counterparts, especially following the 2008 financial crisis. The charts below show debt-to-gdp for relevant emerging market countries. Relative debt outstanding is small when compared to developed countries. 140% 120% Debt as % of GDP (External: public and private) 90% 80% 70% Debt as % of GDP (Local: public only) 100% 60% 80% 50% 60% 40% 40% 30% 20% 20% 10% 0% 0% Source: CIA: The World Factbook. In the 1980s and early 1990s, the tradable market for emerging market fixed income was largely external and denominated in U.S. dollars. s denominated in the local currency began to take hold in the late 1990s. The total market s size was estimated to be $600 billion by the mid 2000s. i The market continued to expand rapidly, comprising approximately $2.1 trillion by the end of ii Emerging market fixed income encompasses three components external debt, local currency debt and corporate debt. External debt is issued in currencies such as the U.S. dollar or euro; the yield of these bonds includes a risk premium based on the issuing government s creditworthiness. The largest risk to external emerging market debt is a default or stresses caused by currency fluctuations. For example, if the U.S. dollar appreciates against the 500 West Madison Street, Suite 3855 Chicago, IL

2 Brazilian reál, Brazil s U.S. dollar-denominated interest expense rises imposing a greater financial burden on the Brazilian government. In contrast, local currency debt is issued in the country s home currency. This adds currency and (local) interest rate risk for U.S. based investors, but also indicates a more responsible and stable local government policy. Since the late 1990s, emerging market countries have continued to stabilize and mature as shown by their inflation and foreign exchange management. This new regime has seen most emerging market countries reduce the risk of a currency crisis by transitioning to more flexible or even floating exchange rate approaches, which are less prone to sudden devaluations. CPI (% YOY) Foreign Exchange Reserves (U.S.$ b) $190 $140 $90 $40 -$10 Source: Standish and JPMorgan as of September 30, Market weighted averages for countries in the JPMorgan GBI-EM Global Diversified Unhedged Index. Volatility in local economies as well as political instability are main risks to the asset class, somewhat explaining its fat tail characteristic. For example, Russia s 1998 default pushed the entire emerging fixed income market into crisis, dragging the asset class to its largest drawdown of -29.5% over a span of 4 months. However, these higher risks are generally accompanied by higher yields, and the asset class has proven to be quite resilient during stress periods experienced by several other asset classes. In addition, approximately 70% of local currency emerging market debt is held by local participants, generally viewed as being a positive. This composition is slowly migrating as the asset class matures and continues to generate interest from various foreign institutional investors, including a notable pick-up from the U.S. since Our analysis references the JPMorgan EMBI-Global Diversified Index from the period January 1994 January This index is representative of the external emerging market debt market. Since February 2003, the analysis references the JPM GBI-EM Global Diversified Unhedged Index to key on local currency emerging market bonds. Both indexes have been deemed the most investable by JPMorgan. As of 10/31/2011, The JPMorgan GBI-EM Global Diversified Unhedged Index had a YTM of 6.40%, duration of 4.49, and remaining life of 6.58 years. By comparison, the Citigroup U.S. High Yield Index had a YTM of 8.29%, 4.37 average duration, and remaining life of 6.82 years. Over 70% of the JPMorgan GBI-EM Diversified Unhedged Index is investment-grade rated (average BBB). The Emerging Market bond asset class has over 40 countries in its universe; however, not all are easily investable or issue debt in local currency terms. The JPMorgan GBI-EM Global Diversified Unhedged Index is comprised of 14 countries whose weights are capped at 10% to avoid bias to more debt-laden countries. The exhibits below compare country composition of the Global and Global Diversified versions of the JPMorgan GBI-EM Index. JPMorgan GBI-EM Global Unhedged Country Weights (10/31/11) JPMorgan GBI-EM Global Diversified Unhedged Country Weights (10/31/11) Thailand, 5.2% South Africa, 8.8% Russia, 4.9% Turkey, 8.0% Brazil, 26.1% Chile, 0.1% Colombia, 2.2% South Africa Thailand 8.8% Turkey Brazil Chile 0.2% Columbia 4.1% Hungary 6.0% Indonesia Poland, 11.2% Hungary, 3.5% Russia 8.4% Malaysia Philippines, 0.3% Peru, 1.2% Mexico, 14.2% Malaysia, 7.6% Indonesia, 6.8% Poland Philippines 0.5% Peru 2.0% Mexico 500 West Madison Street, Suite 3855 Chicago, IL

3 The Global Diversified index pulls approximately 21.5% from Brazil, Mexico and Poland. Brazil is the only country that has outstanding bonds excluded from the Global Diversified Index. Other Index/market characteristics: Only accounts for fixed-rate debt (no floating, callable, putable or convertible). As of 10/31/11, the JPMorgan GBI-EM Global Diversified Index had a market cap of nearly $900b. Emerging market corporate debt is estimated to be approximately $200b in total market cap, and is sparingly allocated to by foreign investors/managers. JPMorgan indices enforce strict liquidity criteria in the selection of instruments by including only securities an investor can deal at relatively short notice and for which firm prices exist, subject to the following: Pricing: s must trade with enough frequency to prevent stale price quotations. Availability: s must be regularly traded in size at acceptable bid-offer spreads and readily redeemable for cash. A reasonable two-way market must exist for the instrument to be included in the index. Replication costs: Investors should be able to replicate the index without incurring excessive transaction costs. Rebalancing: Monthly rebalancing process with review of bond composition lists to affirm that all bonds reflect the most liquid part of the countries appropriate government bond markets. Emerging Market s in the Frontier Engineer Framework The following shows Emerging Market bond returns compared to other asset classes since their 1994 inception. The purple shaded years reflect the JPMorgan EMBI-Global Diversified Index while the blue shaded years are of the local currency benchmark (JPMorgan GBI-EM Global Diversified Index). Note Calendar Year Cash TIPS s HY Large Mid Small REITs Em. Mkts. Commodity Futures Hedge Funds Portfolio Private MLPs Muni (3-7) EM % -3% -3% 1% -1% 1% -2% -2% 2% 8% -7% 9% -3% -2% -14% -2% -19% % 18% 18% 19% 20% 38% 34% 28% 14% 12% -5% 29% 11% 28% 27% 11% 27% % 4% 4% 8% 11% 23% 19% 16% 37% 6% 6% 21% 14% 16% 17% 4% 38% TIPS introduced % 3% 10% 3% 13% 33% 29% 22% 20% 2% -12% -6% 16% 22% 26% 6% 11% % 4% 9% 15% 4% 29% 10% -3% -17% 20% -25% -28% -5% -3% -3% 6% -8% % 2% -1% -1% 2% 21% 18% 21% -3% 27% 66% 22% 26% 21% -8% 1% 20% % 13% 12% 3% -4% -9% 8% -3% 31% -14% -31% 41% 4% -3% 46% 8% 13% % 8% 8% 1% 6% -12% -6% 2% 10% -21% -2% -16% 3% 2% 44% 6% 10% % 17% 10% 14% -1% -22% -16% -20% 3% -16% -6% 44% 1% -20% -3% 10% 14% EMD Local-currency introduced % 8% 4% 10% 27% 29% 40% 47% 37% 39% 56% 32% 12% 47% 45% 4% 17% % 8% 4% 9% 11% 11% 20% 18% 35% 21% 26% 17% 7% 18% 17% 3% 23% % 3% 2% -2% 3% 5% 13% 5% 14% 14% 35% 21% 8% 5% 6% 1% 6% % 0% 4% 5% 12% 16% 15% 18% 36% 27% 33% -2% 10% 18% 26% 3% 15% % 12% 7% 8% 2% 5% 6% -2% -18% 12% 40% 24% 10% -2% 13% 5% 18% % -1% 5% 9% -26% -37% -41% -34% -40% -43% -53% -39% -21% -34% -37% 6% -5% % 10% 6% 4% 56% 26% 40% 27% 29% 32% 79% 30% 11% 27% 76% 7% 22% % 6% 7% 4% 15% 15% 25% 27% 29% 8% 19% 24% 6% 27% 36% 3% 16% 9/2011 0% 11% 7% 5% -2% -9% -12% -17% -6% -15% -22% -4% -5% -17% -2% 5% -2% January 1, September 30, 2011 Performance Metrics (Modern Era) Geometric Annualized Returns Annualized Standard Deviation Growth of $1 million Maximum Calendar Year Return Minimum Calendar Year Return Maximum Drawdown (1988-present) Date Drawdown Began Date Drawdown Ended Duration of Drawdown (Years) 1/1/94-3/31/95 5/1/98-8/31/ Bear: 8/31/00-9/30/ Bear: 10/31/07-2/28/09 Return from 2/28/09 - present Return from 10/31/07 - present 3.3% 6.8% 6.3% 6.3% 7.2% 7.1% 9.1% 6.7% 9.5% 4.5% 5.3% 9.5% 5.4% 6.7% 14.5% 5.0% 11.2% 0.6% 5.7% 3.8% 5.0% 9.0% 15.6% 17.4% 20.2% 21.6% 16.9% 24.5% 18.3% 6.1% 20.2% 15.5% 3.3% 14.1% $1.8 $3.2 $3.0 $3.0 $3.4 $3.4 $4.7 $3.2 $5.0 $2.2 $2.5 $5.0 $2.5 $3.2 $11.0 $2.4 $6.6 6% 18% 18% 19% 56% 38% 40% 47% 37% 39% 79% 44% 26% 47% 76% 11% 38% 0.1% -2.9% -2.9% -2.0% -26.2% -37.0% -41.5% -33.8% -39.8% -43.1% -53.2% -39.5% -21.4% -33.8% -36.9% -1.7% -19.3% N.A % -5.2% -5.4% -33.1% -50.9% -54.2% -52.9% -70.9% -56.4% -61.4% -59.0% -22.2% -52.9% -41.1% -4.4% -29.5% N.A. Feb-08 Jan-94 Nov-88 May-07 Oct-07 May-07 May-07 Jan-07 Oct-07 Oct-07 Jun-08 Oct-07 May-07 Jun-07 Jan-94 May-98 N.A. Oct-08 Jun-94 May-89 Nov-08 Feb-09 Feb-09 Feb-09 Feb-09 Feb-09 Feb-09 Feb-09 Dec-08 Feb-09 Dec-08 Mar-94 Aug-98 N.A % 2.0% 2.0% 10.5% 4.8% 11.2% 8.1% 2.7% 2.0% 10.2% -18.8% 14.5% -3.4% 2.7% -3.5% 1.6% -26.5% 1.7% 1.6% 3.7% 3.5% -2.6% -13.4% -21.4% -29.8% -17.9% -11.2% -43.3% -18.2% -9.0% -29.8% -10.7% 3.4% -29.5% 7.6% 30.4% 23.4% 16.1% -6.0% -44.7% -30.3% -30.6% 21.0% -42.2% -34.0% 27.5% 0.1% -30.6% 54.0% 18.8% 14.1% 2.5% 1.0% 6.1% 6.0% -26.2% -50.9% -53.7% -52.0% -67.1% -56.4% -61.4% -43.6% -21.9% -52.0% -32.7% 9.4% -16.5% 0.3% 32.1% 21.9% 17.8% 74.1% 62.4% 85.3% 71.5% 144.9% 51.1% 89.3% 73.7% 11.5% 71.5% 112.4% 14.7% 54.9% 2.8% 33.4% 29.3% 24.9% 28.5% -20.3% -14.1% -17.8% -19.4% -34.1% -27.0% -2.1% -12.9% -17.8% 43.0% 25.6% 29.3% Emerging Market bonds returned an annualized 11.2% from January September 2011, second best of all asset classes (MLPs). Over the same time, they exhibited a standard deviation of 14.1%. From present, which includes the extreme emerging markets volatility in 1998, skewness and excess kurtosis for Emerging Market bonds was and 13.89, respectively. 500 West Madison Street, Suite 3855 Chicago, IL

4 From October September 2011, Emerging Market bonds had a skewness of and excess kurtosis of This compares to and 7.94, respectively, for High Yield bonds over the same period. Standard deviation was 11.2% for Emerging Market bonds and 10.2% for High Yield bonds over that same period. When adjusting the Emerging Market bond return stream for serial correlation (like we do for all asset classes), the time period standard deviation goes from 14.1% to 13.4%. When further adjusting the short-term return stream to a longer comparable return stream (i.e., relative to Ddenominated Emerging Market bonds , High Yield bonds and U.S. bonds ), standard deviation goes from 13.4% to 18.1% (compared to 12.1% to 16.6% for High Yield bonds). From , Emerging Market bonds outperformed: Emerging Market equity 50% of the time on a calendar year basis (though just twice since 2002). High Yield bonds 63% of the time on a calendar year basis. From , Emerging Market bonds outperformed all other fixed income asset classes (TIPS, U.S. bonds, Foreign Developed bonds) 58% of the time on a calendar year basis. Emerging Market s: Return/Volatility Drivers The compounded growth of $100 chart below shows the total return, duration return, and currency return of the JPMorgan GBI-EM Global Diversified Index. HistoricalReturn Drivers of Emerging Market s (2003-9/2011) $300 $250 $200 GBI-EM Global Diversified Hedged (Duration Return) GBI-EM Global Diversified Unhedged (Total Return) Currency Return $150 $100 Jan-03 Nov-03 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08 Sep-09 Jul-10 May-11 Since 2003: On a month-by-month basis, 61% of the Index s returns were attributable to currency movements. This is notably less than foreign developed bonds over the same period (69% currency attribution). When considering annualized performance, currency contributed to roughly 54% of the emerging market bond total return. This compares to approximately 42% for foreign developed bonds. Emerging Market bonds exhibited a standard deviation of 11.9%. The duration and currency elements exhibited standard deviations of 4.4% and 9.0%, respectively; translating into 37% and 76% of total realized volatility. Foreign Developed bonds exhibited a standard deviation of 8.9%. The duration and currency elements exhibited standard deviations of 2.7% and 8.0%, respectively; translating into 30% and 90% of total realized volatility. Emerging Market s: Fat Left Tails Emerging Market bonds have nearly double the negative skew and 1.5x the excess kurtosis of High Yield bonds (1997-9/2011). If measured since inception (1/1994-9/2011), skewness was and excess kurtosis was Since 2003, skewness and excess kurtosis of the local currency benchmark has been more muted at and This compares to High Yield bonds exhibiting skewness and excess kurtosis of and 9.17 over the same period. 500 West Madison Street, Suite 3855 Chicago, IL

5 The fat tails can be directly related to historical examples of the asset class exhibiting two drawdowns of over 25% (1994 and 1998). Double digit monthly returns have not been out of the realm either. However, it is important to note that emerging market bond fat tails are diversifying to those of other asset classes (i.e., and ). Skewness & Kurtosis ASSET CLASS Expected Risk (σ) Skew Kurt Cash 0.0% - - TIPS 10.5% s 7.2% % HY 16.6% Large 18.2% Mid 19.4% Small 21.9% REITs 23.1% % Em. Mkts. 31.4% Commod- ity Futures 19.6% Hedge Funds Portfolio 9.3% Private 28.7% MLPs 20.6% Muni (3-7) 5.0% EM 18.2% Emerging Market Diversification Benefits: Low Correlations Cash TIPS Historical correlations (through 2010) s HY Large Mid Recent Correlations ( ) Manager Universe 62 Emerging Market bond managers with 114 active products. iii Over half of the managers offer local currency products. 54 mutual funds offered by 37 managers comprising over $52b in assets. iv Small REITs 500 West Madison Street, Suite 3855 Chicago, IL Em. Mkts. Commo d- ity Futures Hedge Funds Portfo lio Privat e MLPs Muni EM Equit y Cash TIPS s HY Large Mid Small REITs Em. Mkts Commod- ity Futures Hedge Funds Portfolio Private MLPs Muni (3-7) EM Cash TIPS s HY Large Mid Small REITs Em. Mkts. Commo d- ity Futures Hedge Funds Portfo lio Privat e MLPs Muni EM Equit y Cash TIPS s HY Large Mid Small REITs Em. Mkts Commod- ity Futures Hedge Funds Portfolio Private MLPs Muni (3-7) EM

6 25 of the mutual funds have existed for more than 3 years and have assets >$50m. Most products with long track records (>5 years) were focused on external emerging market debt. Of the 54 mutual funds, 14 solely focus on local currency emerging market bonds. At least half of these pass DSA s minimum threshold manager screens. It is recommended to bias pure local currency bond strategies run by managers with global expertise in the emerging markets who possess the ability and resources to be highly opportunistic in currency management, issue/domicile selection, and downside risk mitigation. Ways to Invest In Emerging Market s Foreign Developed and/or Core Plus managers allocate to emerging market bonds opportunistically. Emerging Market, Credit, and/or Macro-oriented hedge fund managers invest in emerging market bonds opportunistically or as part of an arbitrage strategy. Strategically allocate to Emerging Market bonds with a strict bias to local currency. Summary Benefits: Higher return potential through yield premium to most developed markets. Diversifying return stream, especially during other asset classes extreme event situations. Direct exposure to growth, social development, and currency appreciation of emerging market economies, which are in a better long-term position compared to most developed countries. Currency is a significant driver (>50%) of local currency emerging market bond returns, though on par or slightly less than the currency impact within foreign developed bonds. Concerns: Volatile asset class (on par with U.S. Equities) driven in large part by currency oscillation and exacerbated by extraordinary fat tails. Elevated currency, fiscal and geopolitical policy risks. Emerging market contagion. Shorter history of local currency bond data (2003) despite comparable external debt return stream stretching back to Conclusion Emerging Market bonds can serve a key purpose within a diversified portfolio. Many institutional and individual investors have ambitious spending requirements. While emerging market bonds have unique risks, they can improve overall risk-adjusted performance. 500 West Madison Street, Suite 3855 Chicago, IL

7 About the Author: Bryce J. Anderson, CFA Alternative Investment Research Analyst As an Alternative Investment Research Analyst at DiMeo Schneider & Associates, L.L.C., Bryce sources and performs operational and investment due diligence on hedge fund managers. Bryce also serves on the firm s capital markets research team. Bryce graduated from The Ohio State University with a BA in Finance and is a CFA charterholder. i JP Morgan, EM Debt as an Asset Class, January 2004; JP Morgan DataQuery, December PineBridge Investments, The Rise and Rise of Emerging Market Debt, January ii JP Morgan DataQuery, December iii evestment Alliance, September iv Morningstar Direct, September West Madison Street, Suite 3855 Chicago, IL