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Emerging Markets

Blending EM Equity and Debt

Three benefits of a multi‑strategy approach to emerging markets

Yoram Lustig, CFA, Head of Multi-Asset Solutions, EMEA

Key Insights

  • A multi-strategy approach to EM investing offers three main advantages. First, it diversifies risk by blending different risk exposures.
  • Second, it offers the opportunity to obtain more durable alpha.
  • Third, it enables investors to combine bottom-up security selection and top‑down management.

Emerging market (EM) stocks and bonds may sit on opposite sides of the equity/debt divide, but that does not mean they should be treated as if they do. EM debt is a growth (risk) asset that has more in common with stocks than with government bonds of developed countries and, as such, should be considered alongside EM equities rather than placed in a separate bucket. Multi‑strategy approaches that incorporate both EM equity and EM debt offer three important advantages over single‑strategy approaches.

Blending Risk Exposures

The first advantage of a multi‑strategy approach to emerging markets is that it blends different risk exposures. EM countries have the potential for their economy to grow quickly and make rapid social gains; they can also be at risk of sudden economic downturn or debt default. EM equity and debt are therefore “high octane” investments that offer both higher possible rewards and greater possible risks than their developed market equivalents. As such, it makes sense to diversify exposure to emerging markets across EM stocks and the three main types of EM bonds: EM hard currency debt, EM local currency debt, and EM corporate debt.

Opening Quote EM debt is a growth (risk) asset that has more in common with stocks than with government bonds of developed countries... Closing Quote

While these four types of EM investments share some characteristics, they remain distinct asset classes, with clearly differentiated behaviors and performance (see Fig. 1). Returns of EM equities and local currency bonds, for example, tend to be driven by EM economic growth, monetary policies of EM central banks, inflation, and currency movements; returns of EM hard currency debt are chiefly determined by the U.S. dollar and the actions of the Federal Reserve; and returns of EM corporate debt are derived not only from macro factors, but also from micro and industry‑specific factors. Correlations between the four asset classes are imperfect and can shift depending on what is happening in the broader economy. Blending them, therefore, provides diversification of risk factors, including local currencies, inflation levels, central bank policies, and industry‑specific issues.

(Fig. 1) Differentiated Exposure

The four main types of EM investments are distinct asset classes.

January 2003 through July 2019. Returns measured in U.S. dollars.

Past performance is not a reliable indicator of future performance
Sources: T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved.
EM Equity: MSCI Emerging Markets Index, EM Debt Hard Currency: J.P. Morgan EMBI Global TR, EM Debt Corporates: JPM CEMBI Broad Diversified, EM Debt Local Currency: JPM GBI‑EM Global Diversified.

Further risk diversification is provided by the opportunity to invest across the whole capital structure of issuing corporations. An investment strategy that includes both an EM company’s stocks and bonds will disperse risk more widely than one focused solely on either.

Opening Quote Emerging markets typically offer more opportunities to generate alpha than developed markets because they are less efficient, less well researched, and frequently come with a liquidity premium. Closing Quote

Finding Durable Alpha

The second benefit of a multi‑strategy approach to emerging markets is that it provides the opportunity to obtain “durable alpha.” Emerging markets typically offer more opportunities to generate alpha than developed markets because they are less efficient, less well researched, and frequently come with a liquidity premium. However, as with any other asset class, it requires manager skill to identify and extract this alpha. Blending different strategies managed by different portfolio managers, even if they work for the same firm, provides exposure to a greater range of manager skill and is therefore more likely to deliver consistent alpha than relying on a single strategy managed by a single manager alone.

Range and diversity are important here. While blending only two strategies (say, EM equities and EM hard currency debt) may result in periods of underperformance, adding EM local currency and corporate bonds to the mix will make this less likely—the wider the range of managers, the less impact it will have when individual managers struggle to generate alpha at any one time, or even if the asset class as a whole is struggling.

Correlations clearly matter too. A group of EM managers generating alpha returns that move in tandem will be less beneficial than a group whose alpha returns are less correlated. It is possible to predict how correlated different managers’ alpha returns will be by undertaking a qualitative analysis of their respective philosophies, approaches, and holdings and then comparing them with their ex‑post returns. The less correlated the alpha, the more durable it will be for the blend. 

Opening Quote Investors can combine bottom‑up alpha generation with top‑down management techniques to build EM portfolios of various risk profiles. Closing Quote

Adding Top‑Down Management

The third major advantage of combining EM equity and debt in a multi‑strategy approach is that it enables investors to combine top‑down management with bottom‑up alpha generation. The bottom‑up approach described above is focused on selecting securities across the broad spectrum of EM equities and bonds. Adding top‑down management makes it possible to also incorporate active currency management and dynamic tactical allocation among the various EM equity and EM debt sub‑asset classes.

Investors can combine bottom‑up alpha generation with top‑down management techniques to build EM portfolios of various risk profiles. The first step to achieving this is to formulate capital market assumptions (specifically with regard to returns, volatility, and correlations) for EM equities and the three types of EM bonds; the second step is to plot the four asset classes along the efficient frontier. Once the risk/return correlation profile of each EM asset class is established, they can be combined to form portfolios with different characteristics.

A lower-risk profile, for example, might comprise 50% EM hard currency debt, 30% EM corporate debt, and 20% EM local debt; a medium-risk profile might be made up of 30% EM equities, 30% EM hard currency debt, 30% EM local debt, and 10% EM corporate debt; while a higher risk profile could include 60% EM equities, 30% EM local debt, and 10% EM hard currency debt. These profiles can then themselves be plotted along the efficient frontier to show what levels of risk and return investors may expect of them.

A More Effective Approach

The strong potential rewards from EM stocks and bonds make them highly sought after during times like the present, when developed market assets are offering comparably meager rewards. By adopting a multi‑strategy approach that treats EM equity and EM debt as comparable—rather than fundamentally different—assets, it is possible to build an EM portfolio that is diversified across risk factors and the capital structure, potentially delivers durable alpha, and benefits from both bottom‑up and top‑down processes of active management. Investors are likely to find that this approach is more effective than treating EM equity and EM debt as fundamentally different asset classes in the same way as developed market stocks and bonds.

Additional Disclosures
MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2019, J.P. Morgan Chase & Co. All rights reserved.

Important Information
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.


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