Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
How indices tell the story in EM debt
If super fund investment staff didn’t appreciate the importance of indices prior to the introduction of YFYS, they should do now. With fixed income, the indices tell an interesting, and in some ways counterintuitive, story.
Notwithstanding the continued popularity of absolute returns-based portfolios, especially with the end investors, the new fund performance test implemented by APRA involves the selection of an index for each strategy which make up the fund’s overall MySuper or default-option return. In the current financial year, this is being extended to individual investment options; what APRA calls ‘trustee-directed’ member options, which include multi-asset strategies.
In the fixed income space, where investors of all shapes and sizes have struggled for more than a decade to eke out much yield, the use of alternative securities and different markets, such as emerging markets and private credit, comparisons between portfolios become complex.
In a recent series of one-on-one meetings held virtually with about 20 clients and other interested funds across Australia, fixed interest specialists at global manager Ninety One were quizzed on the manager’s ‘blended emerging market debt’ strategy as a source of value add for international fixed interest.
Grant Webster, London-based portfolio manager responsible for the strategy, said that, historically, including up to 25 per cent of EMD alongside an allocation to broader-market fixed income, such as the constituents of the popular ‘Global Agg’ index, would have both reduced volatility and increased returns. The Global Agg (Bloomberg Global Aggregate Bond Index) is APRA’s chosen benchmark for super funds’ international fixed interest portfolios in its performance test.
Ninety One uses the J.P. Morgan EMD Blended index as its own reference benchmark for relative performance for the EMD strategy. The average annual blended index return between 2003 and 2021was 7.2 per cent, against 5.8 per cent for the Global Agg. Volatility was 6.4 per cent versus 5.1 per cent. Blending 25 per cent EMD with 75 per cent Global Agg gave an annual return of 6.2 per cent with a volatility of 5.1 per cent.
The structure of the blended EMD index is a lot less concentrated than the Global Agg, with the top three countries (Indonesia, China and Mexico) making up 22 per cent of the index compared with 58 per cent for the Global Agg’s top three (US, Japan and China).
Webster said that using current yields and historical volatilities in the comparison made the improvement in risk-adjusted returns even more meaningful. The Global Agg consists of 73 countries and is 100 per cent hedged to the Australian dollar. The J.P. Morgan Blended EMD index consists of 74 emerging markets with 50 per cent being ‘hard’ currency denominated – mainly USD and euro – and 50 per cent local currency. The USD exposure is hedged back to the Aussie dollar.
For some of the super fund participants in the meetings the discussion provided something of an education in emerging market debt, Webster said. “Many people are under-allocated and they didn’t realise it,” he said.
A surprise for many investors is how well Australia is placed compared with other countries in taking advantage of a blended EMD strategy with the hard currency bonds being hedged back to Aussie dollars and local currencies remaining unhedged.
Webster says: “If you think about US investors, when they buy [US] dollar-denominated bonds in emerging markets they will earn, say, a 5 per cent yield, but that yield comes with a fair amount of volatility… That’s because when investing in local currency EMD they get exposure to the local interest rate but also the currency risk…
“The Australian dollar, on the other hand, has the highest correlation to emerging market debt of any major currency. This high correlation means that, for Australian investors, the volatility of emerging market debt is offset by the volatility of the Australian dollar. The Canadians and Norwegians also get this smoothing.
“But no-one is better positioned than an Australian investor. Furthermore, with a portfolio which blends hard-currency bonds with local-currency bonds, there is a smoothing effect because of the offsetting volatility.”
On the indices themselves, Nadene Moore, Ninety One Melbourne-based senior institutional sales manager, said that the Global Agg, as an investment-grade rated global bond index, could be used as a proxy for the global fixed income opportunity set in the investment-grade space.
It covers both emerging and developed countries and both government and corporate bonds. Emerging markets represent 14 per cent of the Global Agg, skewed towards China and sovereigns rather than corporate debt.
The J.P. Morgan EMD Blended Index better reflected the Ninety One broad investable opportunity set, Moore said, noting that the index contained both investment grade and high-yield issuers. It could also be broken down further, for instance into hard currency sovereign-only securities if such a mandate warranted it.
The Ninety One meetings with super funds, held just prior to the COP26 international climate change conference this month, also included a lot of discussion about ESG as well as geopolitical risks.
Although he has been a regular contributor to the fixed interest conversations with Australian investors, Webster said he had not seen such a level of interest in ESG matters before, reflecting the heightened political tensions around the climate action debate.
There were also a lot of questions about broader geopolitical issues, such as China’s slowing economy and troubled property sector.
But the fundamentals driving emerging economies were generally better than the developed world, with growth prospects looking good, and the capital destruction due to covid-19 tended to be not as bad, he said.
