A pick-up in passive investing in emerging market bonds could lead to pricing anomalies and excessive concentration risk, it is feared.
Passive, benchmark-driven investment is common in many asset classes. But it is problematic in the EM fixed income world because only a small slice of the underlying asset class is included in the major indices. As a result, all passive money will flow into this subset rather than being spread across the wider universe.
The problem is arguably most acute in the world of EM local currency corporate bonds, where just $152bn, or 1.9 per cent, of an estimated $8tn of outstanding issuance is included in the flagship index, the BofA Merrill Lynch Diversified Broad Local Emerging Markets Non-sovereign index.
However, it is also notable for local currency sovereign debt, where the flagship JPMorgan GBI EM Global Diversified index has a market capitalisation of a fraction over $1tn, some 13.4 per cent of the $7.5bn of outstanding paper.
The situation is somewhat better for external, often dollar-denominated debt, with JPMorgan data suggesting coverage of 63 per cent for sovereign debt and 61 per cent for corporate paper, although other estimates are lower, with Jan Dehn, head of research at Ashmore Investment Management, putting the latter figure at nearer 33 per cent.
Overall, the four major indices have a total market capitalisation of $2.8bn, just 15 per cent or so of the estimated $18.5bn of emerging market bonds and other tradable debt in issuance.
“We have a huge market failure in index provision. That gives rise to a problem. We have an excessive concentration of international capital within emerging markets in a relatively small range of countries that are covered in the indices,” said Mr Dehn, who stressed that he did not blame investment banks such as JPMorgan and BofA for the situation.
“We have some investors who, precisely for this reason, hate indices.”
The problem risks being worsened by the rise of passive funds, which funnel money into the securities included in benchmark indices but completely ignore the remaining bonds. As passive investing grows, this could lead to price bubbles in the favoured securities.
Although passive investment is more commonplace in equity markets, exchange traded funds and other index-trackers now control more than a fifth of the US fixed income market, according to BofA. Earlier this month, Moody’s forecast that passive vehicles would account for half of all holdings in the US equity and bond markets by 2021.
Passive investment in emerging market fixed income is less well advanced but appears to be growing rapidly from a low base.
As the first two charts show, ETFs specialising in dollar-denominated and local currency emerging market debt have enjoyed far faster growth than mutual funds, the vast majority of which are actively managed, since 2011, according to figures from BofA and EPFR Global, a data provider.
Since January 2016 alone, hard-currency EM debt funds have witnessed net inflows equal to 50 per cent of their assets at the start of the period, far faster growth (albeit from a lower base) than that for EM equity funds and US bond funds, as the third chart illustrates.
The largest ETF in the sector, BlackRock’s iShares JPMorgan USD Emerging Markets Bond ETF, now has assets of $8.2bn, according to ETF.com. Vehicles from Invesco PowerShares and VanEck have also passed the $2.5bn mark, while Vanguard’s flagship EM debt passive mutual fund has also passed $1bn.
One industry figure estimated that passive strategies now account for 5 per cent of all investment in local currency EM debt and 10 per cent for dollar-denominated EM paper.
“We have started to see more interest in passive investing,” said Mr Dehn, who attributed the trend to lower yields, which means the impact of the higher fees charged by active managers is proportionately greater, as well as investors’ broader love affair with ETFs.
Some, however, dispute how much impact the growth of passive investment had had to date, or is likely to have, assuming it continues to expand.
“The trend is to move to passive, but although the percentage growth has been large, it is still very small, having started from a very small base,” said Jane Brauer, emerging markets quant analyst at BofA. “Thus, I don’t think that the excess demand on those assets would cause serious dislocations.”
Indeed, Ms Brauer added that there were already “dislocations” in the market because EM bond indices often artificially cap a country’s weighting at 10 per cent, meaning they “allocate a higher percentage representation to small countries than large ones, relative to their market capitalisation”.
One industry figure who requested anonymity echoed this argument. He claimed that the dangers of portfolio concentration and pricing anomalies were already present, even with the bulk of money currently being invested by active managers.
He argued that 70-80 per cent of the money held by the typical active manager was simply invested in line with the weightings of their chosen benchmark. Even the bulk of the remaining 20-30 per cent will be pumped into building overweight positions in securities that are in the index, because of the risks of poor liquidity, wide bid-offer spreads and significant tracking error if they venture off-index.
“If the yields are extremely attractive they might play with things outside, but if it’s not in the index, the active guys will not hold much,” he said.
Mr Dehn agreed excessive concentration was already an issue, but believed the arrival of ETFs was only making matters worse.
He argued the problem was most serious in local currency sovereign debt, where the GBI EM Global Diversified index includes just 15 countries, despite “almost every country issuing some sort of dollar paper”.
“The GBI index for developed markets has all economies in it. The problem we have in emerging markets is unique,” Mr Dehn said. “You have an index with a woeful representation in terms of the number of countries. It is where dollar sovereign indices were 20 years ago. If you see a flood of money [being invested] it tends to produce concentration.”
The index providers would argue, however, that their benchmarks are a true reflection of the universe of assets that are genuinely available for foreign entities to invest in.
Countries with capital controls, for example, are omitted, a factor that keeps the huge Chinese and Indian bond markets out of JPMorgan’s indices, and also led to the ejection of Nigeria in 2015. States that slap large tax bills on foreign investors, such as the Philippines, which has a tax rate of 20 per cent, are also excluded.
JPMorgan’s definition of what constitutes an emerging market is also narrower than that of many others, such as MSCI, which operates the benchmark EM equity index. Countries with a gross national income of above $19,000, such as Saudi Arabia, Bahrain, Qatar, the United Arab Emirates, South Korea, Hong Kong and Singapore, are not eligible for inclusion in its EM bond indices.
In the dollar-denominated corporate bond world, one key reason why JPMorgan’s CEMBI Broad Diversified index excludes a meaningful share of available issuance is that the bank strips debt issued by quasi-sovereign entities.
When it comes to local currency corporate debt, Ms Brauer said BofA only includes securities that can be traded via Euroclear, the world’s largest clearing house, which excludes countries such as China and India which “have no interest in making [their debt] Euroclearable”.
If debt cannot be traded via Euroclear, foreign investors would need to appoint a local custodian to hold it. However, many companies choose not to issue bonds that are tradable internationally as they would need to draw up more detailed prospectuses and incur additional legal costs, potentially for little gain.
“The benchmarks tend to be the things that you can buy and hold,” said Ms Brauer, who argued that the problem of excess concentration could actually ease with the emergence of passive funds, as active managers need to focus on securities liquid enough to trade in and out of.
Mr Dehn’s solution to the narrowness of some of the indices is that a multilateral body such as the World Bank, IMF or International Finance Corporation should create their own, more wide-ranging benchmarks.
He argued this would help channel foreign investment into the smaller and poorer countries often omitted from commercial indices, helping meet their development objectives.
“It’s not rocket science. They can do it very cheaply and it would allow a host of poorer countries to access the markets. It’s a no brainer,” Mr Dehn said.
Not everyone is desperate for change, however. Siddharth Dahiya, head of emerging market corporate debt at Aberdeen Asset Management, argued that the growth of passive funds such as ETFs was actually a boon to active managers such as himself.
“In many cases it’s a good opportunity for us. When something happens and sentiment turns and they have outflows and indiscriminately sell off, that gives opportunities to active managers like us to buy at cheap prices,” Mr Dahiya said.
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