Investors should consider out-of-favour emerging market debt funds to play a recovery in the developing world, according to several market commentators, who say they are likely to offer better total and risk-adjusted returns than equities if sentiment towards these regions were to improve.
Emerging markets have fallen further and further out of favour relative to developed markets as several headwinds such as China’s slowing growth and uncertainty regarding its future, plummeting commodity prices and the outlook for US monetary policy have severely weighed on investors’ minds.
But with developed market bonds and equities having performed so well over the last five years or so, many fund managers are looking to increase their allocation to emerging markets over the coming few months as – despite the ongoing concerns – they feel a recovery in the asset class is now overdue. 
Premier’s Simon Evan-Cook is one such manager as he is now looking to up his exposure to the largely hated emerging markets in his Multi Asset Global Growth fund, given that he feels many of the last half a decade’s winners are in for a tough run.
“If you are trying to find an opportunity within global growth, it is going to be emerging markets,” Evan-Cook (pictured) said.
“It’s clearly not the US. Arguably, it could be Europe but the lion’s share of returns have probably gone. It could possibly be the UK as well, but certainly the negative view that most people have on emerging markets makes them very interesting.”
He added: “For us, we have got to decide whether to access that through equities or bonds.”
This may seem strange to many investors, given equities tend to vastly outperform bonds in a market rally.
However, the manager points out that emerging market bond funds have been hurt just as badly as emerging market equity funds over recent years and that there are reasons why former may outperform the latter if sentiment were to change.
Performance of sectors versus index over 3yrs
Source: FE Analytics
“Really, a lot of the damage has been caused through currencies and that’s what has been troubling me a bit because when I speak to emerging market equity managers I have expected them to be thumping the table and saying ‘my God, my portfolio is amazingly cheap’,” Evan-Cook said.
“Some of them are saying emerging markets are cheap, some are saying they are fair value but most of the managers focusing on quality companies are saying they are still cautious. That is because if you separate the currency away, you can see it is that which has caused the hit.”
To illustrate this, Evan-Cook says investors should take a closer look at individual markets such as Brazil in local and sterling terms.
FE data shows, for example, the MSCI Brazil index (with its chunky exposure to commodities) is down a hefty 34.44 per cent year-to-date but when you price that performance in the Brazilian real, the index has only lost 10.13 per cent.
Evan-Cook says that if investors are expecting emerging markets to tear ahead next year, they may need to rethink their potential positioning.
“Does that mean that there is a bear market coming for equities? You have to be careful of that because you can’t rule it out.”
“In which case, maybe you need to give more consideration to bonds. If the opportunity is in currency, then you have to consider bonds as they give you a little more downside protection because the valuations in emerging market equities aren’t necessarily extraordinary because while there is a lot of cheap stuff, large parts of the index are still quite expensive.”
Despite this, many still view emerging market debt as too risky.
Concerns about currency movements and the impact higher interest rates in the US and a stronger dollar as result mean that many believe the asset class will continue to suffer.
“We are not really looking at them right now and they should only ever form a small part of a portfolio. For us, there are enough opportunities out there for us to not go bottom fishing in emerging market debt,” Apollo’s Ryan Hughes told FE Trustnet earlier this year.
However, given that some of the IA Global Emerging Market Bonds sector’s largest funds (such as Pictet Emerging Local Currency Debt, Investec Emerging Markets Local Currency Debt and Pimco GIS Emerging Local Bond) have seen their AUMs fall by more than 60 per cent since May 2013, many feel now is the time to buy back into the asset class.
Source: FE Analytics
On top of that, the average fund in the sector is now throwing off a yield of 5.36 per cent and T. Rowe Price’s Mike Conelius thinks investors cannot ignore that figure in the current environment.
“Although it is likely a Fed rate hike will lead to higher volatility, we do not anticipate that emerging markets will suffer large-scale fallout – as investor positioning is lighter and valuations cheaper than during previous turbulent periods, such as the 2013 ‘taper tantrum’,” Conelius said.
“Rather, with long-term fundamentals in the asset class remaining solid, we view any further short-term weakness as a good buying opportunity for investors.”
“With an index-level yield-to-maturity of 6.44 per cent in external debt and 6.87 per cent in local currency bonds, EM is much more attractive than almost every other asset class from a pure yield standpoint.”
“For example, in many developed sovereign markets, the average index yield is not much above 1 per cent.”
He says those yields are safe given many emerging market countries have large foreign exchange reserves and stronger balance sheets than most developed markets.
Evan-Cook has already taken the plunge and is now actively looking for other emerging market debt funds.
“We haven’t had any real emerging market debt over the years but recently we have added a little bit through Ashmore Emerging Markets Short Duration and we are looking for more.”
“It’s just an interesting opportunity. They are credit specialists and, if anything, they are a deeper value management team than others and are looking at countries that you wouldn’t necessarily want to put your money into but, because of that, the bond issues are so discounted meaning that it only means things to become really God awful for you not to make quite a bit of money.”
“The short duration aspect gives you more certainty that you will get your money back as well.”
According to FE Analytics, the Ashmore Emerging Markets Short Duration fund – which is overweight Russia, Kazakhstan, Brazil and China and currently yields 7 per cent – has returned 16.6 per cent since its launch in July 2014.
Performance of fund versus sector and index since launch
Source: FE Analytics
This means it has comfortably outperformed the IA Global Emerging Market Bond sector (which has lost 4.55 per cent) and is even beating the Barclays Sterling Gilts index.
Rathbone’s David Coombs has also dipped into the market for his Multi Asset portfolios, but he says investors need to be selective.
“Late this year, emerging market debt became interesting on valuation grounds,” Coombs said.
“We have dipped a toe back into the market, but we think the fundamentals are still poor for these assets. We are treading very carefully indeed. Developing nations’ currencies tend to have a tough time when the US tightens its monetary policy and the dollar gains in value – there is still room for high levels of volatility, so we remain nimble.”
“We have small holdings in the Investec Emerging Market Debt Local Currency fund and the Ashmore Emerging Markets Short Duration fund.”
