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Closet trackers are amplifying an EMD liquidity crunch

Closet trackers are amplifying an EMD liquidity crunch

Emerging market debt (EMD) was one of the hottest asset classes of the raging bull market of 2017, with a host of fund launches in the year.

EMD funds banked inflows of more than £9 billion during the period according to Lipper data, with hard currency funds taking £6.75 billion of new money and local currency £2.3 billion.

But risk aversion and a sharpening US dollar rate cycle have led to a shakeout, with €1 billion (£882 million) pulled from local currency funds over the three months to May this year.

Sector funds booked redemptions of $1.5 billion in the first week of July, according to parallel data from flows analyst EPFR Global, the 11th consecutive week of outflows.

Sector watchers are not just concerned about a correction, but fear that some closet-tracker sector funds may intensify an impending liquidity crunch.

Matthew Sethard-Wright, chief executive of boutique EMD fund house 1167 Capital, believes a number of his peers may not be as active as they seem.

He says: ‘It’s a real mix [in EMD]. There are active funds, but it’s clear that some are very passive because they stay so close to the index.’

Sethard-Wright adds that the asset class also tends to see a lot of ‘tourist investors’ who eye a quick buck.

He says: ‘They’ve been coming in for some time, and obviously would have made a lot of money last year buying the index. So they buy the index, and would then look to make a move in April, May or June.’

Sethard-Wright’s Global High Income Bond fund has done reasonably well from some punchy off-index bets – it has no allocation to Brazil for example – and was down -3.5% to the end of June, compared to the index' -6.5% loss.

Others point to idiosyncratic features of the still-developing world of EMD indexation which may herd investors into closely correlated allocations, regardless of their conviction levels, however

Shakhista Mukhamedova, a fund analyst at Brewin Dolphin, says: ‘The way the index is calculated means there are very large allocations to countries like Brazil, which typically yields between 9-13% depending on what’s going on in the country.

‘So let’s say you are a really active fund manager and for example you don’t allocate at all to Brazil, you immediately lose 13% compared to the index.

‘If it was developed markets however, and you didn’t allocate to the UK for example, you’d only lose around 1.5%. So you can see why [EMD] managers would be reluctant to make such a bold call.’

Beware China and Russia

Other factors which can inhibit active management, Mukhamedova adds, are some of the unusual features of trading bonds in countries which do not yet offer the sort of investment infrastucture considered the norm in Europe, North America or Japan.

She says: ‘The trading in emerging market debt is much more complex than in developed markets. For example in Russia, you had to be physically in Russia to buy local bonds, while in India there’s a quota, you can only buy a certain amount of bonds.

‘Also, these countries are just not as developed in terms of their infrastructure for trading electronically, and some of them also don’t want extra overseas investors driving the pricing of their bond markets. They may be looking to protect their currency.’

When allocating to EMD, a lot of fund selectors are increasingly looking at the asset class for income requirements.

These issues are magnified when a reach for yield has attempted to puch large amounts of footloose capital into structurally constrained marketplaces.

Mukhamedova says: ‘We don’t want to take too much currency risk with an income product, and the US dollar duration can be a bit more defensive relative to other EMD funds in a risk-off environment, which as we know can affect emerging markets hard.’

Avoid passives

Richard Philbin, chief investment officer at Wellian Investment Solutions, points out these issues ensure the spread between the cheapest-possible tracker and an active manager is much narrower than in developed world income markets 

With mainstream EMD trackers charging fees of 70bps or even higher, investors have fewer incentives to take on the liquidity risk, he said.

Philbin agreed with Mukhamedova that the market concentration factors may make it harder to discern the real level of active allocation, saying any single month is no more than a ‘snapshot’.

He says: ‘You could have a manager with a 100% active share one month and 3% the next, but it could be that he’s seeing a lot of risk and taking that risk off the table. It doesn’t tell you why he’s doing it or what the trend is.’  

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Richard Philbin
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