Emerging market debt funds have been seen as one of the major beneficiaries of the Fed’s QE programme as investors have had to look outside of the traditional fixed income asset classes for yield. However McQuaker, head of multi-manager investments at Henderson, says he is completely avoiding emerging market debt as he fears that liquidity could completely dry up if macroeconomic conditions and sentiment worsen.
"One of the biggest stories recently has been the very substantial build-up of flows into emerging market debt funds," he said.
"However, they have disappointed and that performance is worrying, because if markets were to fall further from here, and conditions mean investors favour developed markets over emerging markets, and equities over bonds, then investors will want to pull that money out."
"That’s going to be a problem."
"There just isn’t enough liquidity for a high proportion to exit, plus it could cause further issues for the economies themselves," he added.
As McQuaker notes, emerging market debt funds have struggled so far this year. Our data shows that emerging market bond funds from Barings, Investec, Old Mutual and Pictet have nose-dived since Ben Bernanke’s speech about QE tapering, in May.
Performance of funds over 1yr
Source: FE Analytics
The Investec Emerging Markets Local Currency Debt fund had been £2.3bn in size in May this year; however, as a result of significant capital losses and hefty redemptions, it has shrunk to £1.4bn over the last four months.
McQuaker says that a very similar event happened in the build-up to the financial crisis with commercial property portfolios.
The value of commercial property began to fall significantly, causing notable fund groups such as Aviva and New Star to impose restrictions on investors trying to pull their money out as there was not enough underlying liquidity to meet the redemptions.
To see the extent of how many investors were crippled by this crisis, you only need to look at the graph below of the 10-year returns of the IMA Property sector.
Performance of sector over 10yrs
Source: FE Analytics
McQuaker says that although emerging market debt is now in a very similar position to commercial property, he says he has been buying into funds such as Henderson UK Property this year as a way to diversify his income stream.
"An addition that has been quite important for us has been property funds," he said.
"We have 5, 6 or 7 per cent in property, which has played out nicely. The case for property is that there is a much higher starting yield than bonds and there is a higher degree of inflation protection."
"Bonds have been very, very popular in the past and an enormous amount of money has gone into mid-risk bonds such as emerging market debt funds. The way we see it is that a lot of that money might want to come back out again."
"Property was in that same position in 2007 and 2008; however, it isn’t the same now."
"Capital values are increasing; however, we are wary of being in property for too long. We would much prefer to be in early, like we were, and then get out early as well," he added.
McQuaker has managed multi-asset funds at both Gartmore and Henderson during a career running IMA portfolios that spans back to July 2005.
According to FE Analytics, since McQuaker has been running funds in the IMA universe, he has returned 60.39 per cent, while his peers have returned 34.94 per cent.
Performance of manager vs peers since July 2005
Source: FE Analytics
Neil Shillito, director at SG Wealth Management, understands investors’ concerns but he does not believe that emerging market debts funds will face the same catastrophe as property portfolios have in the past.
He says the current level of outflows from emerging market debt funds is likely to be a short-term trend, as he says those economies' "low debt levels and rising currencies" will eventually win out in the end.
"It is an interesting point because last week I had a meeting with our Investec representative and he brought up the very same subject," Shillito explained.
"Investec has a far more relaxed view than Bill McQuaker on the outflows, as it sees it as more of a knee-jerk reaction instead of a deeply rooted problem of long-term capital flight, pointing to the low debt-to-GDP levels you see in the emerging markets."
"When you see debt-to-GDP levels in emerging markets, they tend to be around 40 per cent, while in the developed markets it is something like 120 per cent. So which currencies are going to appreciate over time? It will be the emerging markets," he added.
Shillito says that he does not tend to chop and change his investors’ portfolios and will only reallocate their money if there are scenarios such as in 2008 where it was very clear to see that the economy was in a terrible state.
Because of that, he says he is unlikely to move investors’ money out of emerging market debt funds for the time being.
