Emerging or sub-merging? The impact of currency on returns
When investing in local currency emerging market debt, currency risk can improve returns. But it can also erode performance in times of stress. Understanding how active managers handle this risk is crucial.
2018 has been anything but straightforward for emerging markets. The second quarter was the second worst on record for the JPM GBI EM Global Diversified Index, which returned -10.4% in US dollar terms (only 0.12% shy of the worst which was the third quarter of 2015.) The return for the third quarter 2018 was relatively better at -1.8%, but hidden within this number was a poor return for August, when the index returned -6.1%. The last time the index saw a drop of this magnitude was back in May 2013.
What’s driven this? A combination of a stronger US dollar, concerns about a global trade war and big idiosyncratic risks in emerging markets are to blame. The stars of 2017 such as Brazil, Indonesia and Turkey have seen their fortunes reverse this year.
Although returns have been pretty poor, what’s more interesting is that flows haven’t been as bad. Flows into emerging market local currency debt (EMD LC) funds* remain positive so far this year, circa $4billion. Much of this is due to strong flows in the first few months of the year. Even allowing for a lag between performance and fund flows, what we’ve seen so far is nowhere near the level seen during the difficult years of 2014 and 2015, where a total $11.4billion was taken out of EMD LC funds.
Investing in emerging market local currency debt provides exposure to two potential return drivers: high real interest rates and currency. Of the two, currency tends to be a more significant driver of returns and particularly so in times of stress, where currency is often the first channel in which this stress is reflected.
For fund selectors, understanding a manager’s return composition between currency and non-currency drivers is important because in difficult years such as 2018 (or 2015), it might be easy to dismiss a manager as underperforming but in reality the manager could be true to their stated style. Having a good understanding of the key return drivers means having a reference to measure performance against.
Our analysis of the manager universe* shows that the majority of managers (circa 80% to 90%) prefer to adopt a 'defensive' currency position, by running with lower currency sensitivity than the index. This indicates that managers believe the risk budget is better used in non-currency related areas of the portfolio (such as security selection, duration etc).
This defensive stance has generally been beneficial for periods such as this year or in 2015 when EM currencies performed poorly; however it has is not necessarily detracted in the opposite scenario, where currencies perform well. Take for instance in 2017, when managers with high currency beta didn’t do materially better than their lower currency beta peers. Adopting a more defensive currency position, therefore, hasn’t necessarily meant sacrificing returns.
Adopting a defensive currency position also doesn't mean a passive approach to currency. On the contrary, most, if not all, of the managers take an active approach to currency management. As my colleague Uday Patnaik points out: "a key consideration when looking at EMD is how to take currency exposure". Selective currency exposure is key and therefore for fund selectors, when evaluating a manager's investment process, understanding the manager's approach to currency management is also crucial.
Investors in local currency emerging market debt should first form an understanding of their tolerance towards currency risk as this is a big driver of risk and return. Fund selectors who are bullish on EM currencies will have two possible choices, either select managers that offer this exposure or add selective currency exposure on the side. For those that are bearish, it would appear that no action is required.
*Based on funds in Morningstar that are benchmarked against the JPM GBI EM Global Diversified Index