With assets under management of $6.2trn and more than 30 million investors, Vanguard is often the first name that springs to mind when passive funds are mentioned.
Company founder Jack Bogle created the first index tracker in 1975 with a simple philosophy: since the average active fund will underperform the market after fees, why not just buy the market?
Source: Vanguard
The co-operative structure of the business, with profits re-directed to investors in the form of lower fees rather than paid to external shareholders, has allowed it to slash fund charges as assets have grown, from an average of 0.68 per cent in 1975 to 0.1 per cent today.
Yet while Vanguard is synonymous with index trackers, the company also runs a number of active funds and the manager of one these believes there is one area of the market where a passive approach may not be the best option for investors.
Nick Eisinger, who runs Vanguard Emerging Markets Bond, admitted that anyone who bought a fund tracking his benchmark index at the bottom of the market in March would have done very well over this time. However, he warned they may just be storing up problems for a later date.
“In an environment where the market is rallying, you’d be buying all of the high yield stuff, you’d be buying all the bonds that are very sensitive to market direction,” he explained.
“Now that’s all very well. But you could suddenly find your portfolio is full of very highly concentrated and correlated positions. They are focused around one or two common risk factors: perhaps that’s oil prices, perhaps that’s the price of the United States dollar, perhaps that is something going on with the Treasury market, and so on and so forth.”
Eisinger said this problem is not limited to passive funds and that he has seen many active managers in this area of the market load up on risk, with the debt of countries such as Ecuador, Lebanon, Argentina and Nigeria springing to mind.
He said that a better option for anyone hoping to beat the market would be to isolate some of the risk factors mentioned above and buy only one security playing this theme.
“The way we approach that is we would say, there are these four or five opportunities, they should all behave in a certain way depending whether the market goes up or down,” he continued.
“If you have a view that by the time you put your trade into the portfolio, one of those has underperformed its beta until that point, or you have a view that it has a strong chance of outperforming its beta going ahead, then that’s clearly the trade to do.
“You kind of discard all the other ones because really it is just the market that’s giving you that return. Then you potentially have this big, big headache in terms of your risk management if you’re wrong.”
Yet while the manager admitted there are risks with emerging market debt, he said they are a lot lower compared with most investors’ perception of the asset class. For example, while it is a major story when a country such as Argentina defaults, such occurrences are rare, and even a country as large as Argentina represents a tiny portion of the emerging market debt universe.
In addition, Eisinger said it is possible to further mitigate the impact of a default.
“It typically takes a very long time for emerging market countries to default,” he continued. “It took Venezuela about 10 years, it took Lebanon probably a bit longer than that.
“The point is you see these things coming, you have plenty of signals to prepare for them to manage your risk.
“And obviously governments have plenty of policy tools: the central bank can intervene and cut interest rates, they can buy the bonds, they can go to the IMF and so on and so forth.
“Clearly, those aren’t options available to companies. So just in terms of your visibility and your ability to manage that risk, emerging markets provide you with some pretty interesting opportunities.”
Eisinger said the lower-than-expected defaults are reflected in the risk/return profile of the asset class. Over the past 20 years, emerging market debt has made annualised returns of about 8 per cent – higher even than equities – but with a much lower volatility.
Performance of indices over 20yrs
Source: FE Analytics
In addition, it is one of the few areas of the fixed income market still offering attractive yields – currently at just under 5 per cent.
Yet despite these attributes, investors continue to shy away.
“We generally think of emerging markets as being increasingly important contributors to global economic activity,” said Eisinger.
“As a share of global GDP, they now represent in excess of 60 per cent.
“But emerging market debt is grossly underrepresented in financial indices, whichever one you choose to use.
“Combine that with the fact that even those indices are only giving you an opportunity set that’s a very small share of everything available in emerging markets.
“Then if you overlay that with the fact that investors, particularly at the retail level, will generally not have an overweight, even to that reduced set of indices, you suddenly realise this is an asset class that, despite its very favourable attributes, investors simply don’t hold enough off and should be looking to accumulate further over the years ahead.”
Vanguard Emerging Markets Bond has made 13.13 per cent since launch in December 2019, compared with gains of 2.86 per cent from its IA Global EM Bonds Hard Currency sector and 0.56 per cent from its JPM GBI EM Diversified index.
Performance of fund vs sector and index since launch
Source: FE Analytics
It is $138m in size and has ongoing charges of 0.6 per cent.