Emerging Market Constrained – Product Overview
Investment Strategy
The Emerging Markets Debt Constrained strategy is to outperform the customized blended benchmark throughout the credit cycle. The customized benchmark is a blend between the JP Morgan Asia Credit Index ("JACI") Index and the JP Morgan EMBI Global Diversified Index.
At AUIM, portfolios are managed under a uniform investment philosophy which is driven by a seasoned group of investment and risk management professionals. Performing in a team-oriented environment, the Emerging Markets team focuses on fundamentals, technicals and valuation throughout each step of the investment process and incorporates a combination of both top-down country selection and bottom-up security selection. Our primary investment strategy is to achieve a high level of current income and capital appreciation while taking a level of risk that is acceptable to our clients.
AEGON's Emerging Markets Debt invests primarily in sovereign, corporate, and other debt instruments denominated in the US dollar, and in derivative products that provide underlying exposure to similar instruments. AEGON considers a sovereign as an emerging market based on the selection criteria established for the JP Morgan EMBI Global Diversified (EMBIGD) Index and the JP Morgan Asia Credit Index ("JACI"). In addition, AEGON may consider additional sovereigns as emerging market countries, based on their development stage and credit ratings.
Screening Process
First, we evaluate global macroeconomic conditions and sentiments in core capital markets. Some of the key global macroeconomic measures would include our outlook for core equity markets, energy and non-energy commodity markets, interest rate and inflation conditions and the outlook for the G3 (US, EU, and Japan). Second, we identify countries with improving macro-economic fundamentals. Some of the key fundamental measures would include strong fiscal balance sheets, international reserves, debt ratios, inflation, and economic growth rates. Third, we evaluate the technical backdrop of the sovereign credit. Some of the key technical measures would include market positioning, trading volume, and capital flows. And finally, we analyze the valuation of the instrument under consideration. Some of the key measures would include price, yield, duration, and liquidity. Investing in emerging debt markets requires thorough analysis of the individual sovereign and credit risk. It involves the active management of sovereign, credit, and interest rate exposures. Sovereign risk is defined as the "ability" and "willingness" of a sovereign borrower to meet the obligations agreed to in the issue prospectus.
Portfolio Construction Methodology
AUIM's primary investment strategy in Emerging Markets debt is to achieve returns driven by interest-rate and spread duration, credit risk premium, and coupon payment while taking a level of risk that is acceptable to our clients. AUIM strives to create portfolios that are broadly diversified but contain sufficient exposures to those countries that they feel will contribute to total return and out-performance of their relevant benchmarks. To formulate credit opinions, the AUIM credit analysts perform detailed studies of the underlying credit fundamentals in the countries they cover as well as forecast changes in sovereign and credit yield curves. Sovereign analysis is performed through the use of internal sovereign, credit, and currency models, which include both quantitative and qualitative components. AUIM has also developed a number of analytical models (e.g. an early warning model, Pegasus strategy model, sovereign rating model, currency valuation model, etc.), which utilize data and research from independent services such as Haver Analytics, Economist Intelligence Unit and Business Monitor International.
Buy/Sell Discipline
Portfolio managers and credit analysts meet each morning for a roundtable discussion of market activity and credit-specific headline news. This meeting provides the staff with an opportunity to gauge potential market movements and to generate trading ideas. Investment professionals from our offices overseas in Edinburgh (UK) and The Hague (Netherlands) regularly communicate about market developments. Leveraging the expertise and capabilities of these offices, including contacts with other locations such as Brazil, Mexico, Hungary, China and India, is a key driver of our asset management strategy. To this end we have implemented a global research platform to share research between offices. This global platform allows our worldwide personnel to access research information on the credits that our analysts cover. Research can also be communicated internally via our BlackRock Solutions applications and through discussions between the portfolio managers, credit analysts, and traders. The BlackRock system allows investment personnel to read internally created research reports and allows portfolio managers/traders to consult with credit analysts prior to executing a trade.
The Emerging Markets portfolio manager works with the Emerging Markets strategist to make tactical decisions on regional allocations, as well as with the sovereign analysts to select individual credits within those sectors. A large share of the investment return in emerging debt markets is accounted for by the changes in the risk premium component. The decision to manage the duration and credit risk is taken by the Emerging Markets portfolio manager. The Emerging Markets team also participates in an internal strategic decision meeting which assists with global asset allocation decisions for the firm. The Emerging Markets team then brings together the top-down (sovereign risk) and bottom-up (fundamental credit and technical) views, along with any input on the strategic process, to make buy/hold/sell decisions.
Key to our strategy is the avoidance of credit investments in underdeveloped, overregulated, or competitively disadvantaged sectors. We prefer investments in Emerging Markets credits with improving fundamentals and also greater confidence in the ability and willingness of policy makers to keep inflation and fiscal accounts under control. We prefer credits with a significant contribution to a country's GDP, especially via exports. Additionally, in times of market distress, we look for credits with strong fundamental long-term stories. As a rule, we don't invest in Emerging Markets credits rated below the sovereign in below-investment-grade rated countries. We believe that this combination carries unacceptable risk.
Finally, we emphasize the protection of the value of a client's assets over performance. A number of times we have completely liquidated exposure to credits in which we believed the risk for loss of the asset outweighed the potential for recovery. Sometimes this occurred even at the expense of our portfolio performance relative to the benchmark index.
AUIM has ingrained a strong risk management process into its investment framework. Risk management typically occurs through 5 main ways for AUIM's EM Debt products:
Sovereign and corporate credit research efforts: As already noted previously, AUIM feels the combination of a traditional top-down country research effort and a bottom-up security research effort provides an additional measure of underwriting scrutiny into the sovereign review process. This in turn allows AUIM to have a better understanding of the fundamental downside in sovereign credits throughout the portfolio and allows AUIM to make more grounded risk/reward decisions, utilizing both sovereign and sector-based expertise.
Measurement of Risk/Return Metrics: AUIM's state of the art technology allows for desktop access to a variety of risk-related metrics during the portfolio management process. The primary tool is Blackrock's Aladdin system which provides desktop access to a variety of risk measures including portfolio positioning information, tracking error information, VAR and the ability to measure portfolio risk relative to the benchmark under a variety of market scenarios already established in the system. In addition, the system allows for customization of those scenarios in order to more fully incorporate AUIM's broader market outlook. We can also monitor exposure on a duration bucket basis to better understand the contribution to returns.
Monitoring of Risk limits (Compliance): In addition to the risk metrics available in the Blackrock system, we also have the ability embedded in the system to monitor potential compliance issues on a real-time basis. The system provides for both pre- and post-trade capabilities which help to ensure that the portfolios are managed to client guidelines.
AUIM utilizes an Early Warning Model as part of the sovereign research process. This Early Warning Model allows our team to assess potential problems before they may happen. It tracks key economic and financial variables for countries, alerting the team to trends or levels that could be concerning. These are then evaluated and discussed to determine what may be occurring, and whether further investigation is warranted.
The Local Currency Model is a customized model of foreign currencies that our team can use to estimate potential performance. The Local Currency Model employs a scoring system from "strong sell" through "neutral" to "strong buy" for each currency. In calculating an assessment, the model looks at both return momentum and price momentum in addition to formulating a fundamental score, and then gives us a recommendation.
Trading Execution Strategy
AUIM utilizes the BlackRock Aladdin system, a fully integrated trading, research, portfolio management, and risk platform. This platform is extremely effective in pre- and post-trade compliance, portfolio analytics, as well as communicating written research among various parties. Trade execution is done on a competitive price basis to minimize transaction costs. In addition, AUIM has independent Compliance and Risk Management Groups.
Additional Comments
Investing in Emerging Markets debt involves different types of risks – interest rate, credit, liquidity, sector, currency, and market risks. Bond prices are inversely related to interest-rate changes and rate increases can cause declines in security prices. The use of derivatives (currency forwards, credit default swaps, and interest-rate swaps) may involve other risks (counter-party, price, and liquidity) different from ones associated directly with the underlying assets. Emerging Markets debt instruments are subject to the risk that the issuer may default on its obligations. Emerging local markets instruments are subject to the risk that the foreign currency will decline in value to the U.S. dollar.