The Absolute Insight Emerging Market Debt fund aims to produce positive returns over any 12 month period, irrespective of market conditions. To pursue this goal, the fund has to take an absolute return approach, and retains the flexibility to go both net long and net short, having sometimes been as much as 25% net short. Gross exposure is simply capped at 100% each side, meaning that no leverage is used.
The fund has freedom to allocate over the full universe of emerging market government debt, which is now widely perceived as a relatively safe asset class: both local and external currency emerging markets sovereign debt instruments are now, on average, rated as investment grade. The emerging markets are forecast to make up half of the world economy by 2017, according to the IMF, so the asset class could move towards mainstream status. Yet despite the strong fundamentals – and years of outperforming developed market debt – the space remains overlooked by many investors, with many pension funds only just beginning to invest in emerging markets debt.
Yields currently range from 3.5% to 4.5% for investment grade, and from 6% to high teens for high yield. Although coupon income has contributed part of the fund’s returns, there is no target for carry because the strategy needs to express its best ideas. “It is perilous to invest for income and income alone,” says the fund’s Citwire AAA rated fund manager and Head of Emerging Market Debt Colm McDonagh. Demonstrating the dynamic approach, the fund has recently been net short of external debt. In January, short positions profited through credit indexes, CDS (credit default swaps), and currencies in some countries, such as the South African Rand.
“Some very good countries can still be over-valued”, says McDonagh, who points out that yields on external debt have traded above fundamental values. Differentiation remains a defining feature of the emerging markets, in that Eastern Europe suffers, while Asia grows. Even within a region like Latin America,” there is a big contrast between Brazil and Mexico”, he says, so it makes sense for the team, which includes two portfolio managers and one analyst, to carefully select countries rather than hugging a benchmark. In 2008, losses were limited by the fund having had some hard currency exposures, hedged by CDS. Consequently the fund had a smaller drawdown than the major long only indices. Over the past 3 years, the fund has delivered better risk-adjusted returns than the indices.
The fund’s exposure to emerging market corporate debt, currently including companies in Croatia and Kazakstan, is limited to 30% partly because Insight has a separate fund devoted to this subset of the asset class. Up to 10% can be invested in non-traditional emerging markets. For instance a 1.5% position in Greece has generated gains from the bond market recovery associated with the country’s debt write down, bail outs, and policy making. Maturities can extend all the way from 3 month currency forwards out to 30 year bonds.
Risk management sets constraints in terms of risk and volatility, with instruments are calibrated according to their volatility. The risk system has moved from Value at Risk to duration or interest rate sensitivity based, and portfolio construction has also seen a recalibrated risk reward approach that can include stop losses. Internal layers of monitoring include the ARIC (Absolute Return Investment Committee), the Quantitative Strategy Team, and the Risk Management Team – all in addition to the external UCITS oversight from regulators and service providers. Given daily dealing, the fund pays close attention to the liquidity of bond markets, and has avoided the liquidity bottlenecks that have hampered some emerging markets hedge funds.
“The emerging markets always offer a huge range of scenarios”, he says, whether they are political or whatever else, and the fund began 2013 with a gain of 1.1% in January. The EM universe is always evolving. Insight are closely following these changes, and are alert to exploit new opportunities.