Investment Strategy
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 philosophy incorporates a medium to long-term investment horizon. Currencies can move erratically in the short term, but in the medium to long-term they can bear evidence of the amount of flows into or out of the currency in question. Increases in exports, foreign direct investment, portfolio investment, etc., all contribute to movements in currency, and these are generally fundamental in nature. It is important, therefore, to understand long-term trends in currencies and countries, including their trade and investment dynamics, to be able to profit from investment opportunities that may become available.
AEGON's Local Markets Fund invests primarily in emerging market bonds and other debt instruments denominated in the local currency of the issuer, 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 GBI-EM Index. In addition, AEGON may consider additional sovereigns as emerging market countries, based on their development stage and credit ratings.
AEGON's Local Markets strategy seeks to outperform the JP Morgan GBI-EM Index (USD un-hedged) by investing primarily in sovereign instruments denominated in local currency. These securities are issued by governments in emerging markets. Local-currency denominated instruments appreciate in value when the underlying denominated currency rises against the USD and when local interest rates are either steady or declining.
The development of the Emerging Markets philosophy and process has been sustained since 1999. As the years have progressed and the market has developed, AUIM has continued to evolve the process to generate maximum value for clients. In addition to the traditional research effort, during the past six years AUIM has enhanced the ability to add value in the EM market with expansion into EM local markets. AUIM has more fully incorporated this local markets expertise into the daily process in order to mitigate risk in existing holdings and uncover attractive opportunities in the broader EM opportunity set.
Screening Process
First, we identify countries with improving macro-economic fundamentals. Some of the key fundamental measures would include strong fiscal balance sheet, international reserves, debt ratios, inflation, and economic growth rates. Second, we evaluate the technical backdrop of the sovereign credit. Some of key technical measures would include market positioning, trading volume, and capital flows. Third, we analyze the valuation of the instrument under consideration. Some of the key measures would include price, yield, duration, and liquidity. Investing in emerging local markets requires thorough analysis of the individual sovereign and currency risk. It involves the active management of credit risk, interest rate, and currency exposures.
Portfolio Construction Methodology
The AUIM Emerging Markets Local Currency strategy seeks to provide clients with risk-adjusted returns in U.S. dollar terms. In this investment strategy, we seek to exploit opportunities by analyzing global macroeconomic themes, including interest rates and currencies. The emerging markets team covers the entire opportunity set in fixed income – sovereign, corporate, interest rates, and currencies.
We employ a disciplined portfolio construction process that is based on a top-down bottom-up approach. The primary objective is to construct a portfolio that can deliver consistent risk-adjusted returns. Our risk-budgeting framework looks at sources of expected returns from interest rates and currencies. The top-down approach is used to analyze the country selection decision, and to make the sovereign allocation relative value decision. The bottom-up approach is used to analyze the security selection decision, and make the instrument allocation decision in accordance with the portfolio strategy and guidelines.
The Blackrock Solutions platform allows us to perform stress tests and scenario analyses using past and future events. We incorporate fundamental macroeconomic analysis (economic growth, inflation, fiscal, monetary, and political factors) based on market consensus and internal analysis. Additionally, we incorporate assumptions involving market technical conditions (yield curves, interest rates, liquidity, exchange rates) and valuations (external and local debt). We analyze the strengths and weaknesses of sovereigns to determine the expected path of sovereign rating, interest rates and exchange rates. We achieve portfolio positioning using an iterative process that maximizes the risk-return profile, based on investment guidelines.
The desired local currency portfolio and instruments is achieved using best execution and trade allocation policies at AUIM. The internal compliance team, risk management team, and the emerging market team monitor the risks of the local currency portfolios on a regular basis. The Blackrock Solutions platform gives us the ability to analyze risk at the aggregate and instrument level.
Local markets, by its nature, achieve some return via its currency component. One of the key reasons for local markets assets to outperform when translated to US dollars is when the local markets currencies themselves appreciate against the US dollar. We believe that we are in an extended period of local currency appreciation; one that could be beneficial to local markets accounts when based in US dollars. Of course, this differs by currency, and the alternative is also true. Our team works to identify and invest in currencies that should outperform. Our emerging markets local currency investment style is one of a total return approach. This gives us maximum flexibility to make active allocation across sovereigns and instruments in the emerging markets local currency universe.
We use the widely used J.P. Morgan Government Bond Index – Emerging Markets ("GBI-EM") and the Diversified version (""EMGD") to analyze the local currency portfolio positioning for beta opportunities. The analysis of the peer universe is also an important component.
Buy/Sell Discipline
The primary team is comprised of four individuals with long experience in global emerging markets fixed income. The portfolio managers, sovereign, 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 interaction with our investment teams located in Brazil, Mexico, Hungary, China, India, and Turkey is a key driver of our asset management strategy. To this end we have implemented a global research platform to share research within our global investment management 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 and currency components. 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. Emerging Markets portfolios are valued daily on our Blackrock Solutions platform. We are able to monitor daily risk analytics and positions, including ex-ante what-if exposures at the aggregated issuer, sovereign, region, and portfolio levels. The team spends a significant amount of time on research analysis of sovereign, corporate, interest rates, and currencies. It is extremely important to get the sovereign and currency decision right; as these are the largest sources of local currency returns.
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.
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 local markets 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 and interest-rate swaps) may involve other risks (counter-party, price, and liquidity) different from ones associated directly with the underlying assets. Local markets instruments are subject to the risk that the foreign currency will decline in value to the U.S. dollar.