Amid the recent spike in volatility, registered investment advisers are rethinking how they approach emerging markets. Concerns over such factors as the cooling pace of growth in China and political turmoil in Turkey have sparked an exodus from emerging-markets indexed funds and exchange-traded funds (ETFs). The IShares MSCI Emerging Markets ETF (EEM) fell 9.5 percent during the week of January 27 alone.
“In the trailing one-year period, EEM has now seen $14.5 billion leave the fund via redemptions, and the VWO [Vanguard FTSE Emerging Markets ETF] has lost nearly $13 billion during the same time frame,” says Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, a boutique firm in Philadelphia that handles block trading for independent wealth managers. “Clearly, many managers have decided to step to the sidelines for now.”
Sage Capital Advisors, a La Jolla, California–based wealth management firm, has largely pulled out of emerging markets. “Currency and interest rate risk dominate the bearish case in the near term,” says Sage managing director Tim Dyer. The firm, which manages more than $148 million in discretionary assets, primarily uses ETFs for managing tactical exposures. According to Dyer, the recent concerns over the health of emerging-markets economies suggest significant danger in holding large, concentrated exposures in emerging-markets debt or equities. “There are opportunities in emerging-market equities on a case-by-case basis,” he says. “But for now, any allocation to it I suggest be dramatically reduced, if it hasn’t been already.”
“To use an Excel analogy, this a circular reference,” says Matthew Andrews, portfolio manager, director of research at Private Capital Advisors, Inc., a New York–based multifamily office. “It all stems from issues in the developed markets, then leads to Chinese infrastructure spending and spills over into the commodity-centric economies that fed off Chinese demand, which drove more deficit spending. When borrowing rates spike and growth slows, you have a problem.”
Luz Padilla, a portfolio manager for the $489 million DoubleLine Emerging-Markets Fixed-Income Fund (DBLEX) at DoubleLine, a Los Angeles–based registered investment adviser and money management firm, sees one silver lining in the panoply of EM assets: dollar-denominated debt.
Investment managers have tended to lean toward equities in the emerging-markets space because they felt that was where they were going to get the biggest bang for their buck, Padilla says. But this asset class also carries higher volatility as well as a strong sensitivity to currency shifts, leaving portfolios vulnerable during sudden rotations — like the one currently under way.
Padilla, a lead manager at the TCW Group in Los Angeles prior to joining DoubleLine, launched the fund in 2010, and DBLEX has outperformed benchmarks with year-to-date as of February 6 pullback of only 2 percent, despite recent market jitters. This beats the J.P. Morgan emerging-markets bond index global diversified, its benchmark index, which has pulled back by about 3.6 percent as of February 6.
DoubleLine is weathering the storm better than many competitors, thanks in part to its strategy of eschewing local currency debt and sovereign debt in favor of dollar-denominated bonds from corporate issuers. “To accept the volatility of holding local currency, debt investors should expect to be compensated with higher returns,” says Padilla. “We simply haven’t seen the potential for those returns in the past.” As recently as the end of January, U.S. dollar–denominated Turkish debt was still in positive territory for the year. “People would be surprised to hear that, since Turkey has been one of the worst performers in the market,” she says. “On the currency side, yes, but on the dollar-denominated side, no.”
The return for U.S. dollar–denominated Turkish debt for the month of January was up 0.47 percent and the return for Turkish lira–denominated bonds was down 5.08 percent. The return numbers come from the country returns of the J.P. Morgan emerging-markets bond index global diversified, a U.S. dollar–denominated index and the J.P. Morgan government bond index-emerging markets (GBI-EM) broad diversified, which is not denominated in dollars.
Andrews concurs that fixed-income allocators with local currency exposure face great concerns, in part because of the dollar-denominated debt that investors like Padilla are holding. “The so-called fragile five — Brazil, India, Indonesia, South Africa and Turkey — are entering a cycle of currency devaluation while servicing external debt in dollars and euros. It’s true that they may have built up large currency reserves, but the stress will still be significant,” says Andrews.
In the long term, Padilla remains confident that allocations to the emerging-markets debt sector, carefully considered, will help investors enjoy relative outperformance going forward. “This is a secular improving credit story at its core,” she says. “The best way to exploit this asset class is by identifying specific opportunities that are going to migrate up the credit curve from B to BB to BBB.”
