Performance Review 2005Paul McNamara: "A strong performance from the high-yielders Turkey and Brazil supported Fund returns. Bond exposure in Indonesia was a drag on the Fund as the market worried about the fiscal impact of a sharp pick-up in high oil prices."
Performance Review 2006
Paul McNamara, Caroline Gorman: "2006 was disappointing for the Fund, when risk that was cut in May and June was not added back, thus failing to capitalise on the recovery into the end of the year. The high yielders Turkey and Brazil suffered from excessive offshore positioning against a backdrop of rising US Treasury yields in the first half of the year."
Performance Review 2007
Paul McNamara, Caroline Gorman: "FX appreciation was the key driver of Fund returns as the market searched for carry. High yielding FX such as Turkey and Brazil were key beneficiaries and these were the top performers of the Fund. Emerging market currencies were also supported by accelerating growth."
Performance Review 2008
Paul McNamara, Caroline Gorman: "In 2008 the Fund ended in negative territory and underperformed the benchmark. The losses were predominantly driven by emerging market FX exposure in the Fund’s largest positions, in Mexico and Turkey in particular, but also in Poland and Brazil. Overweights here were also the key drivers of the underperformance versus the index."
Performance Review 2009
Paul McNamara, Caroline Gorman: "A very strong performance for the Fund in 2009, as well as a substantial outperformance of the index. The key drivers were Brazil and Russia, both in absolute terms and versus the index. Brazil’s currency benefited from its superior growth relative to much of the rest of the world in the wake of the 2008 credit crisis. Meanwhile a number of credit positions in Russia did well for the Fund."
Performance Review 2010 - Year-to-Date
Paul McNamara, Caroline Gorman, Denise Prime: "Emerging market fixed income in 2010 has attracted significant inflows, particularly to the long end of yield curves. High yielding markets like Indonesia benefited from this, and this has been the top performer ytd, followed by Mexico, which has also attracted flows in light of low US yields and its entry to the WGBI index. These were also the best performance relative to the index. The Fund has risen 14.4% ytd to September 2010 and has outperformed the index by 9.2 percentage points over the same period."
Performance since 2005
Paul McNamara, Caroline Gorman, Denise Prime: "Over the full period since 2005 emerging market debt as an asset class has matured substantially. Fund returns have been generated predominantly from high yielding markets such as Turkey, Brazil, Indonesia and Mexico in which the Fund has generally been overweight. Governments have done much to improve their balance of payments positions, debt levels and structure of their debt markets, all of which have been reflected in the trend towards lower yields on local currency debt, and FX appreciation."
Investment Process and Strategy – How does the Fund Manager Invest?
Paul McNamara, Caroline Gorman, Denise Prime: "Our investment process combines top-down and bottom-up factors as well as fundamental, quantitative and market technical considerations.
These considerations drive our decision if we aim to invest in a local market or not, and if so, over which time horizon (strategically or tactically), to which degree (index neutral, underweight, overweight, or out-of-index), in which performance dimension (currency and/or yield curve and/or local credit), and through which instrument. It also drives how aggressively or defensively we aim to be positioned in the aggregate as well as in which performance dimension of the overall portfolio.
The first step in the Investment Process is to filter out those markets we judge to be at risk of crisis. We do this on the basis of a system developed internally.
The framework of this system is that Emerging Market crises have a variety of drivers – public and private sector debt crises, inflationary episodes, policy mismanagement. Obvious indicators – especially market indicators such as exchange or interest rates fail to pick out the problems but every crisis has shown some of the following group of indicators showing signs of disequilibrium:
- Falling foreign exchange reserves
- Falling ratio of fx reserves to broad money
- Zero or negative real interest rates (forward basis)
- Rapidly rising inflation
- Rapid rise in Credit/GDP ratio
- High & Rising Current Account/Exports of Goods and Services
- Uncompetitive exchange rate (Import/Export growth strongly positive)
- (Qualitative) Vulnerable banking sector to external shocks
- (Qualitative) Rapid deterioration in fiscal position.
Overall these indicators generally will highlight when a market is either accumulating increased vulnerability to a change of sentiment from domestic or foreign investors, or that such a change in sentiment is in fact occurring.
We will generally avoid countries scoring three or more negatives on this checklist. We would regard five or more as a red flag.
Country & Instrument Selection
Our investment philosophy generally has the duration decision secondary to the currency decision – we generally do not hold hedged bonds as both from an empirical and theoretical point of view this is not a successful strategy. Overall we regard long duration as an opportunistic strategy for adding alpha to the portfolio. Bond markets are more dependent on more reliably forecastable factors such as interest rates, but generally do not add material diversification to a currency strategy (bonds don’t rally in a market where the currency is weak).To increase risk more generally we will generally increase currency exposure. In short, currencies for beta, bonds for alpha.
Interest rate and currency risks are assessed using extensive in-depth fundamental research also incorporating quantitative (relative) as well as market technical (e.g. direct or related investment flows) considerations as illustrated below. For instance, we extensively evaluate international and domestic economic, political and market developments, global and local tactical and strategic capital and investment flows, liquidity, risk appetite and volatility, domestic debt scheduling and flexibility as well as international and local demand dynamics for local debt, international capital flows and pricing patterns in related investment fields such as commodities and emerging markets equities, but also stress test scenarios like liquidity crunches and global spill-over effects.
In addition to the extensive in-depth analytical work we conduct, we also interact closely with local government representatives, policymakers and consultants. Team members also undertake regular visits to all relevant countries. While the vast majority of research is conducted in-house, we also source complementary information from external sources, such as supranational organisations, brokers or the rating agencies.
More specifically, we use a matrix to assess the 23 deep and (relatively) liquid local markets we assess on a regular basis, and run a similar assessment on other markets we may wish to assess on an ad hoc basis. We assess each currency in terms of 14 indicators covering the state and dynamics of the external balance of payments, the stability of domestic monetary developments, the level of real interest rates and the likely path of interest rates.
Examples of indicators assessed:
State of Balance of Payments: Current Account Balance/Current Account Credits
BoP Dynamics: Export Growth
Monetary Developments: Growth of Broad Money/Growth in FX Reserves
Path of Interest rates: Nominal interest rates
Some indicators will be normalised to allow for cross-market comparison (for example to make growth in FX reserves in US$ terms comparable across countries. Some indicators may be forecast by the investment team.
We then rank the markets we examine on the basis of these 14 indicators and allocate under- and overweightings of markets on the basis of the rankings. The actual scale of the weightings is purely qualitative on the basis of the managers’ assessments – and often subject to feedback from the Risk Management stage of the Investment Process (see below). We have investigated attempting to produce more formal model output – a more quantitative allocation approach – and found this deeply unsatisfactory, because of the risk of excessive concentration of risks in country allocations and because of the difficulty of factoring in the (very important) top-down view of the global economy.
Having established currency allocations, the fund makes a decision of what duration to hold in the markets to which allocations are made. The framework used for this assessment is basically the same as that used for duration allocations – one of “mean reversion” globally in yield curve steepness and real interest rates. By systematically allocating to markets with the highest real interest rates and steepest curves and staying out of markets with low real interest rates and inverted curves, we expect to produce superior returns. At its simplest “steep curves flatten, flat curves steepen”.
The threshold for an acceptable level of curve steepness or real interest rates is determined by the global environment.
Once we have defined from a top-down perspective if we aim to invest in a local market, over which time horizon (strategically or tactically), to which degree (index neutral, underweight, overweight, or out-of-index), and in which performance dimension (currency and/or yield curve and/or local credit), we select the most efficient instrument to reflect our view. For instance;
- if we aim to take exposure towards the local yield curve, local currency and local credit, we will typically select debt instruments – if available – issued by local governments, agencies or corporates denominated in the local currency.
- If we aim to take exposure towards the local yield curve and the local currency but not towards local credit, we will typically select debt instruments – if available – issued by organizations or western financial institutions denominated in the local currency and/or linked to the local currency and/or local credit. Where such bonds are not available, we will synthetically replicate such exposure through longer-dated FX forward contracts.
- If we aim to take exposure principally towards the local currency but not towards the local yield curve and the local credit, we will typically use FX forward contracts. FX forward contracts and FX derivatives are also applied for hedging purposes, usually on a tactical basis.
In evaluating debt instruments, we will also consider local and international ownership, current and future supply and demand dynamics, current and future market liquidity, broker inventories and bid/offer pricing patterns, as well as security specifics, such as:
- Interest duration
- spread duration
- basis points – value (BVBP)
- spread BVBP
- legal covenants
- linkage and/or
Corporate Credit Risk
Corporate Credit Risk has not been an important driver of the investment process in recent years as we felt credit spreads did not provide sufficient compensation for the lower liquidity of instruments. Generally local currency corporate debt is neither a large nor a growing market (corporates prefer to borrow in US$ and hedge) so we see this as a useful but minor source of potential alpha. Generally the Fund holds only securities of “system” banks – those banks whose importance to the economy at large is sufficient to imply a sovereign bailout. Other holdings will be of marginal size, on the basis of assessments by the Firm’s corporate risk specialists.
More broadly, we hold no more than 10% of the fund in potentially illiquid securities (securities where a short-notice liquidation is likely to incur a material discount)
Research / Investment Strategy
The top-down process step "Investment Strategy" determines - against the backdrop of our global fundamental, quantitative and market technical assessment - the style and market risk profile of the portfolio.
Investment strategy is set by the Investment Committee, headed by the Chief Investment Officer. The Investment Committee meets formally on a weekly basis. Subject to market circumstances, this interval may be shortened. The investment strategy consolidates all the views from the individual specialist teams and formulates the overriding style exposure and market risk stance for all portfolios managed by the group.
Besides the formal Investment Committee meetings, intense interaction and exchange of ideas is also taking place between the individual specialist teams on an ongoing basis which ensures that we fully and effectively leverage the various areas of fixed income investment expertise available to us on the same floor.
The fundamental analysis assesses the current and future path of the global and regional economies and its implications on individual asset classes both at the global and regional level.
The quantitative analysis assesses the relative current and future attractiveness of individual asset classes against the fundamental backdrop both at the global and regional level.
Market Technical Analysis
The market technical analysis assesses the implications of the fundamental and quantitative backdrop for liquidity, volatility and market flows for individual asset classes both at the global and regional level.
Portfolio construction and implementation is the result of the investment process. The portfolio construction set-up is described in the illustration below."
Paul McNamara, Caroline Gorman, Denise Prime: "We remain positive on the prospects for local emerging markets.
The global backdrop is favourable. We don’t believe the US will fall into a double-dip recession, partly because of the Federal Reserve’s stated commitment to inject further liquidity if necessary. Additionally, China has already proved to be extremely adept at fine-tuning its economy and we believe it will successfully engineer a soft landing. Meanwhile, excess capacity should keep a lid on inflation – although food prices merit watching – so interest rates can remain low for some time.
Exceptionally low yields in developed markets mean demand for emerging market assets will persist. Not only do emerging markets offer stronger fundamentals – higher growth rates, lower debt levels and healthier banking systems – than developed markets, but bond yields are higher, too. Additionally, emerging market currencies should outperform, because capital will flow to countries offering the best growth prospects.
Furthermore, institutional investors are underweight the asset class. As they become more informed about its portfolio benefits (low correlations, high Sharpe ratios, etc.), they are moving to rectify this. Anecdotal evidence suggests this trend is just beginning, so a structural shift in demand, away from developed market assets and towards emerging market assets, should underpin the asset class over the next few years."