THE NEXT PHASE IN THE EVOLUTION OF EMERGING MARKET DEBT INVESTING

Transcription

1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. This strategy is offered by Insight North America LLC (INA) in the United States. INA is part of Insight Investment. Performance presented is that of Insight Investment and should not specifically be viewed as the performance of INA. Please refer to the important disclosures at the back of this document. THE NEXT PHASE IN THE EVOLUTION OF EMERGING MARKET DEBT INVESTING OCTOBER 2017 > While the emerging market debt universe has evolved beyond recognition over the last two decades, the way that investors approach the asset class has been slower to evolve. It is time for investors to look beyond constrained benchmarks and toward a total return approach.

2 Today, the investable EMD universe exceeds $16trn... Whereas in 2000, EMD represented about 2% of global fixed income, today that proportion is closer to 25%

3 THE NEXT PHASE IN THE EVOLUTION OF EMERGING MARKET DEBT INVESTING WHILE THE EMERGING MARKET DEBT UNIVERSE HAS EVOLVED BEYOND RECOGNITION OVER THE LAST TWO DECADES, THE WAY THAT INVESTORS APPROACH THE ASSET CLASS HAS BEEN SLOWER TO EVOLVE. IT IS TIME FOR INVESTORS TO LOOK BEYOND CONSTRAINED BENCHMARKS AND TOWARD A TOTAL RETURN APPROACH. WHILE EMERGING MARKET DEBT HAS EVOLVED, INVESTMENT APPROACHES HAVE LAGGED Emerging market debt (EMD) has come a long way since the turn of the millennium. The dramatic and structural improvement in macroeconomic fundamentals prompted a rapid expansion in both the breadth and depth of emerging market (EM) capital markets. And for EMD specifically, this transformation has changed the asset class beyond recognition. Today, the investable universe exceeds $16trn (Figure 1) across local and hard currency sovereign and corporate debt. Whereas in 2000, EMD represented about 2% of global fixed income, today that proportion is closer to 25%. We believe the investment proposition has never been more compelling. While the asset class has evolved, the same cannot be said for the methods investors use to gain exposure to it. The use of traditional benchmark-constrained long-only strategies, either single-sector or blended, continues to dominate investment allocations. However, such strategies suffer from several limitations that inhibit a manager s ability to capture the most compelling beta opportunities: Static sector allocation: Benchmark-constrained blended EMD strategies have predefined weights to any combination of the three main EMD subsectors: local currency sovereign debt, hard currency sovereign debt and hard currency corporate debt. They are limited in terms of the degree to which the asset allocation can deviate from this neutral position. When allocation changes do occur, they tend to be incremental and infrequent. While these blended approaches offer enhanced diversification benefits over single-sector strategies, they still remain constrained in terms of the manager s ability to actively avoid segments of the EMD universe where the prevailing view is negative. Forced country exposure: Tracking-error and other constraints can also limit the extent to which benchmarkconstrained strategies can deviate from prescribed benchmark country weights. During times of idiosyncratic, country-specific stress Brazil s recent economic and political challenges, and the Russia/Ukraine Crimea crisis being two such examples the best exposure might be outright country avoidance. Indeed, at the height of their respective crises, Brazil and Russia maintained close to a 10% weighting in the most widely Figure 1: The EMD investable universe is growing rapidly and now stands at $16trn $bn YTD 2017 EM local corporates EM local sovereigns EM external sovereigns EM external corporates % of EM within global fixed income market (RHS) % Source: JPMorgan, September 2017.

4 followed EM local currency index 1. For benchmark-constrained strategies outright avoidance is often unpractical and costly in terms of risk budget usage. Drawdown capture: Single-sector benchmark-constrained EMD strategies have structural and indiscriminate long positions to the underlying beta of that sector. This is clearly not an issue when on the right side of the credit or interest rate cycle, but when the market corrects, investors are exposed to the full drawdown impact with limited scope to mitigate. THERE IS A BETTER APPROACH We believe total return EMD strategies represent the next phase in the evolution of EMD investing. At their core, these strategies can actively and rapidly allocate to the most attractive segments of the market while avoiding the least attractive, without being restricted by tracking error or traditional benchmark constraints. They seek to generate returns from both income and capital growth. While benchmark-aware, they are not benchmarkconstrained and the manager typically enjoys large degrees of freedom to seek out the most attractive investment ideas and the best ways to access the structural beta of the market. Unlike a benchmark-constrained strategy where the benchmark serves as the starting point, a total return strategy effectively starts with a clean slate. Every exposure is an active decision. WHAT DOES TOTAL RETURN MEAN IN PRACTICAL TERMS? Dynamic sector allocation EMD is often couched in terms that infer homogeneity. As the performance table in Figure 2 demonstrates, however, EMD is anything but homogeneous. Annual performance divergence each of the three key sectors can vary substantially in any given year. During the 2008 global financial crisis for example, hard currency sovereign and corporate credit underperformed, while local currency debt s currency-driven negative return was softened by a strong positive return from the underlying bond exposures. In the aftermath of 2013 s taper tantrum episode it was local currency debt s turn to underperform, while corporate debt stood out as an oasis of relative calm. Meanwhile, in 2015, the magnitude of performance dispersion the best and worst performing EMD sub-sectors was in excess of 16% (see final column, Figure 2). These episodes demonstrate that being tied to a benchmark effectively removes a manager s ability to avoid considerable drawdowns. In a blended total return EMD strategy, the manager can actively and decisively allocate these sectors in response to evolving market conditions. When conditions are detrimental to a specific sector the manager retains large degrees of freedom to reallocate capital away from it and toward the more promising sectors within the opportunity set. In other words the manager can actively manage beta exposures away from expensive or fundamentally deteriorating sectors towards cheap or fundamentally improving sectors. Figure 2: Historical annual EMD sector performance A B C Years EM local currency debt (unhedged USD) Bond return Currency return EM hard currency sovereign EM hard currency corporate 'Best' minus 'worst' from A, B and C % 6.7% 10.7% 6.2% 3.9% 14.2% % 10.8% -14.5% -12.0% -15.9% 10.6% % 10.3% 10.6% 29.8% 34.9% 12.9% % 11.4% 3.8% 12.2% 13.1% 3.4% % 8.4% -9.4% 7.3% 2.3% 9.1% % 13.7% 2.7% 17.4% 15.0% 2.4% % -0.3% -8.7% -5.3% -0.6% 8.4% % 8.2% -12.8% 7.4% 5.0% 13.1% % 3.3% -17.6% 1.2% 1.3% 16.2% % 9.4% 0.5% 10.2% 9.7% 0.5% Source: Insight, JPMorgan, September We use the JPMorgan Global Bond Index Emerging Markets Global Diversified (USD, unhedged) to represent EM local currency debt, the JPMorgan Emerging Market Bond Index Global Diversified (USD) to represent EM hard currency sovereign and the JPMorgan Corporate Emerging Market Bond Index Broad Diversified (USD) to represent EM hard currency corporate. 1 JPMorgan GBI-EM Global Diversified Index.

5 Complete country selection freedom Being fully flexible and unconstrained, total return strategies typically have no intrinsic country exposure biases. When the manager s view of a given country s economic fundamentals is deteriorating, he or she can simply maintain a zero exposure to that country. Conversely when the view is positive, the manager can take a more concentrated exposure. We believe such flexibility can add substantial value. Figure 3 presents monthly local currency sovereign (USD, unhedged) and hard currency sovereign returns for two major EMD countries, Brazil and South Africa. Brazil is an example of an EM country that was recently on the receiving end of negative political and economic headlines, while South Africa itself not immune from political and economic noise represents an example of a high-beta country historically prone to more extreme returns. Strikingly, each returns distribution exhibits non-normal tendencies, characterised by fat tails and a large degree of positive skew. South African local currency debt, for example, has produced 25 months of negative returns greater than -5% and 38 months of positive returns greater than +5%, with currency a key driver of performance. Monthly drawdowns in excess of -10% are also not uncommon. December 2015 s political roller coaster that saw President Jacob Zuma sack Finance Minister Nhlanhla Nene only to change his replacement within a week saw South African local currency debt assets sell-off -13%. Similarly, May 2013 s taper tantrum episode prompted a sell-off close to -15% during that month. Brazil was a considerable underperformer at the height of its domestic economic and political woes in 2014 and 2015, when a deep recession and pervasive corruption scandal rocked the country. Brazilian local currency debt generated a negative cumulative return in excess of -30% over this two-year period. Against such a negative fundamental backdrop, outright avoidance was perhaps the most prudent approach to Brazilian assets. For single-sector benchmark-constrained strategies a zero weighting would have been impractical, consuming a considerable amount of the manager s risk budget usage through tracking error. At the time, Brazil s weight in the widely followed JPMorgan GBI-EM Global Diversified Index was 10%. For a total return EMD strategy on the other hand, the manager would typically have had complete freedom to maintain a zero exposure to Brazil if the fundamental view warranted. Figure 3: Brazil and South Africa local currency debt and USD hard currency sovereign debt monthly returns distributions 40 Frequency (months) <-5% -5% and -4% -4% and -3% -3% and -2% -2% and -1% -1% and 0% 0% and 1% 1% and 2% 2% and 3% 3% and 4% 4% and 5% >5% South Africa local currency debt (USD unhedged) South Africa hard currency sovereign debt 40 Frequency (months) <-5% -5% and -4% -4% and -3% -3% and -2% -2% and -1% -1% and 0% 0% and 1% 1% and 2% 2% and 3% 3% and 4% 4% and 5% >5% Brazil local currency debt (USD unhedged) Brazil hard currency sovereign debt Source: Insight, JPMorgan, September We use the Brazil and South Africa sub-components of the JPMorgan GBI-EM Global Diversified Index, May 2003 to September 2017.

6 A similar narrative applies to Russia in late 2014, a time when the Crimea conflict was in full swing and oil prices were collapsing. Between July 2014 and April 2015, Russian local currency debt assets experienced tremendous volatility, declining close to -60%, before strongly rebounding +60% (from a lower base) in early 2015 (Figure 4). Russia constituted close to 10% of the JPMorgan GBI-EM Global Diversified Index just as the crisis was deepening, making it difficult to fully avoid for a benchmark-constrained investor. For a total return EMD manager who was concerned about the prevailing negative backdrop, a decision could have been made to completely avoid Russian exposure altogether. As the value proposition became compelling once more in early 2015, the manager could have resumed a more concentrated exposure. As it was, Russia s benchmark weight sank to just 3.71% in January 2015, the point which marked the trough of the sell-off and when a considerably larger exposure was probably justified. When a market bottoms out and buying opportunities emerge, total return strategies have the potential to re-engage with concentrated, high-conviction allocations to capture the most compelling beta opportunities. THE END RESULT While the EMD investment universe has evolved and deepened considerably over the past two decades, most investors continue to access the asset class through traditional, benchmarkconstrained approaches. In our view, such strategies suffer from several limitations that inhibit a manager s ability to capture the most compelling beta opportunities and expose investors to unnecessary drawdown risks. Ultimately, total return EMD strategies seek to achieve more structural beta exposure, but in a way that removes cyclicality, manages negative tail risks and focuses on only the most attractive investment ideas. In other words, they seek to focus on cheap or fundamentally improving beta while avoiding expensive or fundamentally deteriorating beta. They can do this through dynamic asset allocation and through including only the highest conviction country ideas. While benchmark aware, these strategies have high levels of flexibility and large degrees of freedom to achieve this outcome. As the EMD universe has evolved dramatically, these strategies represent the next phase in the evolution of EMD investing. Ultimately, total return EMD strategies seek to achieve more structural beta exposure, but in a way that removes cyclicality, manages negative tail risks and focuses on only the most attractive investment ideas. Colm McDonagh, Head of Emerging Market Fixed Income Colm joined Insight in November 2008 as Head of Emerging Market Fixed Income, responsible for all emerging debt strategies. Prior to joining Insight Colm s previous roles included partner at Hydra Capital Management (an emerging market fixed income boutique) and Head of Global Emerging Market Debt at Aberdeen Asset Management. He began his career at Bank of America in 1996 as an emerging market Eurobond trader. He has invested across the wide spectrum of the asset class through long only and alternative strategies. Colm holds a B.B.L.S. honours degree in Finance and Law from University College, Dublin. Figure 4: Russian local currency debt assets experienced considerable volatility during % Add Russia: +60% recovery (from lower base): January 2015 to April Avoid Russia: -60% drawdown: July 2014 to January Jun 14 Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 JPMorgan GBI-EM Global Diversified Russia Index weight Russia local currency debt cumulative return (USD, unhedged) Source: Insight, JPMorgan, September We use the Russia sub-component of the JPMorgan GBI-EM Global Diversified Index, June 2014 to April 2015.

7 IMPORTANT DISCLOSURES This document has been prepared by Insight North America LLC (INA), a registered investment adviser under the Investment Advisers Act of 1940 and regulated by the US Securities and Exchange Commission. INA is part of Insight or Insight Investment, the corporate brand for certain asset management companies operated by Insight Investment Management Limited including, among others, Insight Investment Management (Global) Limited, Pareto Investment Management Limited, Cutwater Asset Management Corp., and Cutwater Investor Services Corp. Opinions expressed herein are current opinions of Insight, and are subject to change without notice. Insight assumes no responsibility to update such information or to notify a client of any changes. Any outlooks, forecasts or portfolio weightings presented herein are as of the date appearing on this material only and are also subject to change without notice. Insight disclaims any responsibility to update such views. No forecasts can be guaranteed. Nothing in this document is intended to constitute an offer or solid action to sell or a solid action of an offer to buy any product or service (nor shall any product or service be offered or sold to any person) in any jurisdiction in which either (a) INA is not licensed to conduct business, and/or (b) an offer, solicitation, purchase or sale would be unavailable or unlawful. This document should not be duplicated, amended, or forwarded to a third party without consent from INA. This is a marketing document intended for institutional investors only and should not be made available to or relied upon by retail investors. This material is provided for general information only and should not be construed as investment advice or a recommendation. You should consult with your adviser to determine whether any particular investment strategy is appropriate. Assets under management include exposures and cash, and are calculated on a gross notional basis. Regulatory assets under management without exposures shown can be provided upon request. Unless otherwise specified, the performance shown herein is that of Insight Investment (for Global Investment Performance Standards (GIPS ), the firm ) and not specifically of INA. See the GIPS composite disclosure page for important information and related disclosures about firm performance. Past performance is not a guide to future performance, which will vary. The value of investments and any income from them will fluctuate and is not guaranteed (this may partly be due to exchange rate changes). Future returns are not guaranteed and a loss of principal may occur. Targeted returns intend to demonstrate that the strategy is managed in such a manner as to seek to achieve the target return over a normal market cycle based on what Insight has observed in the market, generally, over the course of an investment cycle. In no circumstances should the targeted returns be regarded as a representation, warranty or prediction that the specific deal will reflect any particular performance or that it will achieve or is likely to achieve any particular result or that investors will be able to avoid losses, including total losses of their investment. The information shown is derived from a representative account deemed to appropriately represent the management styles herein. Each investor s portfolio is individually managed and may vary from the information shown. The specific securities identified are not representative of all the securities purchased, sold or recommended for advisory clients. It should not be assumed that an investment in the securities identified will be profitable. Actual holdings will vary for each client and there is no guarantee that a particular client s account will hold any or all of the securities listed. The quoted benchmarks within this presentation do not reflect deductions for fees, expenses or taxes. These benchmarks are unmanaged and cannot be purchased directly by investors. Benchmark performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. There may be material factors relevant to any such comparison such as differences in volatility, and regulatory and legal restrictions the indices shown and the strategy. Transactions in foreign securities may be executed and settled in local markets. Performance comparisons will be affected by changes in interest rates. Investment returns fluctuate due to changes in market conditions. Investment involves risk, including the possible loss of principal. No assurance can be given that the performance objectives of a given strategy will be achieved. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to consult their tax and legal advisors regarding any potential strategy or investment. Information herein may contain, include or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals expansion and growth of our business, plans, prospects and references to future or success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as anticipate, estimate, expect, project, intend, plan, believe, and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Our actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Insight and MBSC Securities Corporation are subsidiaries of BNY Mellon. MBSC is a registered broker and FINRA member. BNY Mellon is the corporate brand of the Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally. Products and services may be provided under various brand names and in various countries by subsidiaries, affiliates and joint ventures of the Bank of New York Mellon Corporation where authorized and regulated as required within each jurisdiction. Unless you are notified to the contrary, the products and services mentioned are not insured by the FDIC (or by any government entity) and are not guaranteed by or obligations of the Bank of New York Mellon Corporation or any of its affiliates. The Bank of New York Mellon Corporation assumes no responsibility for the accuracy or completeness of the above data and disclaims all expressed or implied warranties in connection there with. Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of MBSC Securities Corporation (in its capacity as a registered broker-dealer) to offer securities, (ii) officers of the Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds and (iii) associated persons of MBSC Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms. Disclaimer for Non-US Clients: Prospective clients should inform themselves as to the legal requirements and tax consequences within the countries of their citizenship, residence, domicile and place of business with respect to the purchase and ongoing provision of advisory services. No regulator or government authority has reviewed this document or the merits of the products and services referenced herein. This document is directed and intended for institutional investors (as such term is defined in various jurisdictions). By accepting this document, you agree (a) to keep all information contained herein (the Information ) confidential, (b) not use the Information for any purpose other than to evaluate a potential investment in any product described herein, and (c) not to distribute the Information to any person other than persons within your organization or to your client that has engaged you to evaluate an investment in such product. Telephone conversations may be recorded in accordance with applicable laws Insight Investment. All rights reserved

8 FIND OUT MORE Insight Investment 200 Park Avenue, 7th Floor New York, NY Call charges may vary by provider. Institutional Business Development Consultant Relationship Management Client Service Management