Q: How has the fund evolved since inception and how does it differ from its peers?
Schroders launched its emerging-market debt Absolute Return business in 1995, and the current team has managed the current Absolute Return Strategy since late 1998. The fund’s two primary goals have always been to avoid losing money in any rolling 12-month period and to maximizing returns. That sets us apart from nearly all other EMD funds. Most EMD funds follow a benchmark; few target positive absolute returns regardless of the market environment.
We manage just under $4 billion in total in this strategy. We can invest in both external and local currency debt, as well as local currencies in one active strategy. Following our in-depth country analysis, we actively allocate to carefully selected countries within our broad investment universe of over 50 countries, across a range of different securities that we believe will offer the best risk-adjusted returns.
EMD is frequently subject to high levels of volatility and crises. These events can often wipe out the gains made during the good years. Thanks to a flexible and active approach to country and instrument selection, as well as a focus on preserving capital, we provide long term consistency along with low volatility. We have a low correlation to global bonds, global equities, and to the many standard indices that represent our asset class.
Q: What is your investment process?
We have historically generated a gross rate of return of about 8.5%, with a volatility of about 6% or 7%. Our investment approach is fundamentally driven. The team has developed a unique investment process, designed specifically for Absolute Return investing in the EMD universe. Our research process is the primary source of ideas for investments. Country analysis forms the core of the investment process and is the main source of return generation. When analyzing single countries, four types of analysis are applied to each country. Fundamental research is complimented by use of three other three key pillars of analysis undertaken: quantitative, technical and sentiment analysis.
Within each country, we can buy the currency itself, local government bonds issued in local currency and subject to local interest rates of varying durations—everything from a one-year bond all the way up to a 30-year bond—and external debt, typically issued in dollars but sometimes in euros.
Once we find a country we like, we decide what to buy from among these three investments. We employ this flexibility on a country-by-country basis, which also sets us apart, as other EMD funds typically focus on just one sector, which we do not find optimal over the long term. The freedom and flexibility to avoid poorly performing countries will, as it has been in the past, be as much a benefit to performance as the ability to focus on attractive opportunities.
Q: Would you give an example to illustrate your approach?
As an example of our strategy’s flexibility, if interest rates are expected to rise in a favored country the currency may become interesting as a potential investment. However, if interest rates are anticipated to fall, we can consider long-duration local bonds and maybe fully or partially hedge the currency. In today’s post-crisis investing environment, we might want a combination of investments and avoid countries still experiencing hangover effects from the recent crisis.
Emerging markets between the late 1990s and the early part of the millennia were turbulent, Mexico (1994), Asia (1997), Russia (1998), Argentina (2001), Brazil (2001–02), and so on. Many investors lost money. Then came a boom, not just in emerging market growth, but in their middle class spending, foreign investment and infrastructure. Commodity prices rose, along with global growth, and eventually foreigners began to invest in emerging markets.
Inevitably after such a boom period, excessive credit growth, a loss in competitiveness as currencies became overvalued, as well as poor political, monetary, and fiscal policy manifested itself in many EM countries. Surpluses turn into deficits, GDP growth rates slowed, and populist spending or increased corruption became evident. Our analysis identified many of these factors around 2010–11, by which time many investors had significantly increased exposure to emerging-market countries. Capitulation often comes as market participants realize assets are expensive and when fundamentals are weak, which precipitates an investment exodus and a subsequent sharp fall in markets. It can take years to encourage reinvestment into emerging markets, for investors to realize the value on offer, as well as what has changed, especially if investors have experienced past high volatility and subsequent losses.
The last three or four years have featured a very significant adjustment in both currency and bond valuations, with many currencies losing up to half their value against the U.S. dollar; Brazil, Russia, India, and others have seen significant currency adjustments, reflecting deteriorating underlying fundamentals and pressure created by investors withdrawing capital.
Bond yields spiked as well in local markets. Some bond yields doubled, going from low single-digit to in some cases to high single- or even double-digits. Credit spreads moved to a certain degree, albeit with relatively muted activity compared to currencies and local bonds.
Crisis typically generates change, consistently so in the case of emerging markets. The encouraging macro-economic adjustments accomplished recently by a number of EM countries are now increasingly evident.
Q: What is your outlook for the immediate future?
Despite strong returns year to date, there is still a long way to go before many key markets return to levels where they look expensive. Far from being a message of doom, ours is one of optimism for many different emerging market countries. The concept of emerging markets as one asset class is interesting because no two countries are ever the same. While some countries are evolving from this post-crisis era with a positive trajectory, some countries still struggle with large overhangs of debt, slow economic growth, and no fiscal or political reform, making their markets unappealing to invest in today. But that is typical for emerging markets. It is up to us investors to employ maximum flexibility and freedom to pick those countries boasting cheap valuations and positive fundamentals, and to continue to avoid those where further troubles may still lie ahead.
Q: What are the key steps in your research process?
Our comprehensive country analysis employs four separate and independent levels of analysis: fundamental, quantitative, technical and sentiment. Fundamental country analysis forms the core of the investment process. Politics is inevitably the most qualitative element and focuses on risks and opportunities. Economic outlooks, as well as market forecasts for external and local debt and for the exchange rate, are also prepared. These forecasts are made on both a three- and 12-month horizon and are the central output of this analysis.
Thereafter, a country risk model aims to provide an objective input into our inevitably more subjective fundamental analysis. Countries are scored reflecting the country’s risk based on six key factors. We make extensive use of chart analysis: the volatile and frequently momentum-driven nature of many EMs makes both long- and short-term chart analysis of price patterns a valuable tool. Chart analysis is particularly useful in supporting decisions on timing and aggressiveness of positioning. Chart analysis also often generates investment ideas which are then fully researched through fundamental analysis. Sentiment analysis attempts to discover how other market participants are positioned and/or how likely they are to change their positions in the future. Accurate readings can support our own assessment of risk/opportunity in markets.
At the final stage of the analysis, the team agrees 12-month total return forecasts for each investable asset. Assuming such attractive returns are forecast, investments are made subject to the team’s liquidity based diversification rules. In order to aid investment decision making, the team maintain a scorecard for all countries and their respective markets in our universe, thus enabling the team to rank opportunities based on the output from our investment process.
Q: Do you use any benchmark measures?
As an absolute-return fund, and because no one benchmark captures our asset class entirely, most clients compare our returns against cash. We believe our investment method is optimal to achieving the best risk-adjusted return because our key metrics are return and risk, not benchmarks or tracking error.
Q: Can you provide one or two examples of your country selection?
In a good selection of emerging countries there is now increasingly clear evidence of both cheap valuations and improving fundamentals, something not seen for many years across the asset class in general. Our current positive outlook involves selected EM local bonds recovering in the coming 12 months, following the collapse of recent years, coupled with a strong recovery in EM currencies from their current oversold level. However, it remains obvious that investors are broadly underinvested and that they remain doubtful about the potential of the asset class; the recent recovery in EM assets continues to be met with skepticism by market participants. The 2016 rebound is generally described as a “bear market rally” with most commentators considering the ongoing rebound in prices as lacking strong fundamental support.
Indonesia is probably the most convincing example of a country where the dislocations and the positive policy inflexions of recent years are now followed by encouraging signs of growth recovery. This recovery is supported by a recently initiated credible easing cycle and by a noticeable acceleration in badly needed infrastructure spending. Indonesian assets continue to respond handsomely to these positive trends given the strong gains recently made, and only recently have investors turned from negative to increasingly positive on the country’s outlook.
The same pattern can be seen in Indonesia, Mexico, Hungary, Poland, Russia, and many more, even including South Africa. Often investors will typically avoid EM countries in the ‘post crisis’ and ‘recovery’ period but only start allocating to EM counties when valuations have reached expensive levels.
Q: Do positions that cannot be hedged pose a problem in these countries?
We keep things simple, buying only cash bonds, foreign exchange forward contracts; all long only and unleveraged. Concerning local debt, we have never had a problem hedging currency risk, the only thing we do hedge.
If we think interest rates will be cut in a country we favor, which would be detrimental to the currency, we buy long-dated debt and hedge the currency. If we want to own something that is essentially a cash proxy, then we buy short-dated bonds and hedge the currency.
Q: What was your experience with the Russian crisis?
Russian assets fell out of favor when oil prices fell sharply, along with the increase in political risk in 2014. In early 2015 the strategy invested in US dollar-denominated Russian government debt at high yield levels to take advantage of the high spread, and rode the recovery until the yield on US dollar-denominated bonds looked less attractive. At that point, we rotated that exposure into local Russian government bonds where the yield was significantly higher, which also provided us with full exposure to the currency. Currently, we have about 6.5% in local Russian investments.
Q: What is your portfolio construction process?
Anything in the portfolio is there on merit, because the Team thinks that over the coming 12 months it will generate a good positive return and the proven investment process we have indicated that we should own it. When we buy into a market we will only buy a small position and wait for this to move into profit before any additional exposure is added. In addition, if the position does not move into profit within a set period then this would trigger a review which would frequently result in the position being sold. We also operate a portfolio stop-loss discipline whereby if the fund falls by a certain percentage in any month, then all positions are automatically reduced across the board. Further losses will then lead to a further reduction in overall exposure.
Our flexibility is evident when you compare our positioning at the end of last year to where we are today. In December, our cash position approached our 40% maximum, and 15% of the fund was exposed to currencies. The duration on the fund was less than one year and we had no corporates, no external debt, and were defensive.
Today, the fund looks considerably different. Fund duration is just over 4 years, 76% of the fund is exposed to currencies, we have exposure to about 20 different countries and the fund’s yield is just under 5%. We have increased risk as positions become more profitable during the course of the year.
Q: How do you define and manage risk?
Our risk centers on the fund’s performance. Without complicated instruments, we avoid most counterparty risk—we do not use swaps, leverage, or a prime broker. Our risk lies in how our fund performs. We enforce diversification based on liquidity and have a strict fund stop-loss rule. While all absolute-return managers have different versions of this, ours is simple: if the fund falls by a certain percentage in any month, then all positions are automatically reduced across the board. Further losses will then lead to a further reduction in overall exposure. Now, historically, that means the fund can and does draw down when volatility picks up significantly, but it is very limited if you consider it relative to a benchmark approach.
In 2008, for example, the fund drew down 9.9% from peak to trough. Because of our strict stop-loss rule, we avoided losing 20% or 30% and got the fund’s performance back to flat for the year. In 2015, the fund drew down again, by about 8.9%, but we have since recovered the entire draw down, having stopped poor performance relatively early.
This strict stop-loss rule ensures we limit poor performance, and once we insulate the fund against volatility, we wait until an opportunity presents itself to re-invest, starting with small positions and building to where we are fully invested.
Risk management is for us: controlling drawdowns, holding onto the gains of the boom period, and then, when the time is right, being flexible enough to reinvest in the best current opportunities.
