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By systematically minimizing exposure to poorly compensated risk factors, we believe an emerging local debt (ELD) strategy can deliver long-term returns similar to the market with substantially lower volatility and drawdowns. In Wellington’s ELD Advanced Beta strategy, we seek to:
- Reduce exposure to developed market currency risk by diversifying exposure to the investor’s home currency
- Minimize duration risk in long-maturity bonds and countries with flat yield curves
- Selectively hedge exposure to lower-yielding currencies
INVESTORS IN EMERGING LOCAL DEBT FACE A DILEMMA. The asset class has historically offered attractive yields and total return potential, as well as the opportunity to diversify exposures to other asset classes in a global portfolio. However, volatility in ELD markets can be substantial, much of it driven by large fluctuations in currency exchange rates that can lead to sizable drawdowns. For example, the JPM GBI-EM Global Diversified Index lost 15% in the first 23 days in March, as the COVID-19 pandemic began to take hold around the world.
This type of volatility in the asset class has not been limited to once-in-a-century global catastrophes, however. Consider that from mid-April 2013 through the end of 2015, the index declined by a cumulative 29% in US-dollar terms (Figure 1). Many investors understandably found such volatility unacceptable, as evidenced by more than US$58 billion in institutional outflows from the asset class between May 2013 and March 2016 (Figure 2).
To make matters worse for those who liquidated their ELD holdings, the index then appreciated by more than 30%, cumulatively, in the two years ended December 2017. The investors who exited near the bottom weren’t around to experience the rebound. This foregone appreciation could be regarded as the hidden cost to investors of high volatility and drawdowns. In our view, these historical examples are particularly relevant as we reflect on the current crisis.
In traditional ELD, not all risks are created equal
Our research has shown that investors in a traditional ELD approach encounter risks that are not all equally compensated with long-term expected returns, and that are not all likely to be appropriate or desirable for institutional investors domiciled in developed markets. In our Emerging Local Debt Advanced Beta approach, we seek to…
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