White Paper
Following a perfect storm for EM assets and years of chronic underrepresentation in global portfolios, we believe the time is right for investors to increase their allocations. Both cyclical and fundamental factors now favour EM, whilst the asset class will continue to provide significant diversification benefits at much lower valuations. Moreover, increased geopolitical risk, policy uncertainty and elevated volatility provide fertile ground for alpha generation.
However, as information becomes more widely available, the asset class is now better researched and increasingly efficient. At the same time, market structures are shifting, with local markets now dominated by domestic investors. A changing investment landscape demands a different approach. We see a strong case for a truly active, nimble and contrarian process that exploits market ‘blind spots’ and differences in behaviour between investors to generate asymmetric returns.
EM Debt at a crossroads: the case for an active, nimble and contrarian process
The era of low hanging fruit for alpha generation is long gone. As access to information proliferates and Emerging Markets become more efficient, outperformance based solely on fundamental analysis is becoming increasingly challenging.
Against this backdrop, the asset class will likely become bifurcated between investment behemoths and nimble asset managers. It is now more difficult to generate alpha in mainstream, liquid Emerging Markets as they have become more structurally efficient, are well researched, and price discovery is increasingly transparent. Despite this, large quasi-passive funds will continue to focus on these markets, given their size and liquidity requirements. This situation is likely to foster even more herd behaviour and consensus-driven investing. Whilst momentum strategies may enjoy short-term success in this environment, when the music stops, these mainstream markets will be vulnerable to sharp reversals. In the longer term, this new paradigm of increasingly scarce alpha should suit truly active, nimble and contrarian processes that focus on overlooked, mispriced areas of the market.
With this in mind, we built our EM Debt process around a number of key convictions and areas of differentiation:
- We do not see EM Debt as a homogenous asset class, but rather a collection of sub-asset classes with different alpha drivers and catalysts. We have four risk buckets: sovereigns; corporates; FX; and rates.
- We are non-regional in our approach. Our funds are truly global, rather than simply representing passive stacking of regional funds.
- We are value-based contrarian investors. Although we may miss some short-term momentum opportunities or enter/exit investments too early, we believe this approach is particularly effective at generating alpha in the long term.
- We take the view that not everything is interesting. EM Debt is a large asset class, but it has matured, and in our view large swathes now offer few inefficiencies to be exploited.
- We only focus on areas where we believe we have an edge. In the sovereign and corporate credit buckets, our focus is on specific inflection points with a contrarian mindset, both on the long and short sides. In the FX and rates buckets, we focus on flows and the investor base. Investment processes based solely on fundamental research are unlikely to generate alpha as the asset class is becoming better researched, with fewer arbitrage opportunities.
- We tend to focus on overlooked, mispriced and under-researched markets rather than spending time on small, low-conviction trades.
- We rely on a scenario-building, probability-based approach rather than clearcut directional views. Instead of believing that we have more accurate macro data or forecasts than the wider market, we study the consensus and positioning, aiming to identify market ‘blind spots’ or behavioural biases.
- We separate alpha from beta. All alpha trades are clearly identified in the portfolios, with sponsorship and accountability.
Generating alpha in EM Debt: focusing on scenario mappings and behavioural biases
We believe that it is almost impossible to outsmart the market with more accurate forecasts than a plethora of sell-side research analysts, buy-side competitors, global think tanks and development banks. There is a more than a touch of hubris baked into proprietary forecasting models. For this reason, we do not invest according to forecasts that are based on assumptions of what could be in front of us, but neither do we invest looking in the rear-view mirror. Indeed, we are not momentum investors expecting the future to be like the past.
Instead, we focus most of our attention on ‘blind spots’ in market consensus, because this is usually where major risks and opportunities lie. We:
- Invest based on scenarios. All too often the market seems to ignore potential outcomes, partly because of entrenched beliefs and biases. These ‘repressed’ or ‘overlooked’ scenarios are added to our map of possibilities as they may end up materialising in a classic ‘return of the repressed’ phenomenon. In other words, we try to identify market ‘taboos’. When we think that the probability of a taboo scenario occurring is more than zero, we analyse the impact on the risk/reward dynamic of a trade.
- Invest according to probabilities rather than views. We tend to avoid directional views, proprietary forecasts or ‘gut feelings’. Once we have built a comprehensive map of possible scenarios, we assign probabilities to potential outcomes.
- Analyse potential mispricings due to market technical factors and volatility. Here we mostly focus our attention on:
- Smaller issuers where information is less widely available, or those that are not well covered by the buy- and sell-side.
- In-vogue issuers that are part of consensus investment beliefs (for example due to trendy thematic research), or those with potential/actual crossover participation. These are often subject to cycles of euphoria and capitulation.
- Distressed opportunities which are prone to mispricing amid sudden market capitulation due to broad-based market scepticism.
Turkey turnaround. Before the 2023 presidential election, the vast majority of buy- and sell-side participants were excitedly forecasting an opposition win. Conversely, a potential Erdogan victory was portrayed as an unambiguous negative, given his heterodox policies and authoritarianism. The market was largely unwilling to explore a scenario whereby Erdogan won but then pivoted towards economic orthodoxy. Whilst we did not have a directional view on the election outcome, we could see in rock-bottom valuations that the ‘Erdogan pivot’ which eventually came to pass was a repressed and therefore mispriced scenario for market participants.
It was a similar story in Argentina. Before the 2023 election, Milei was portrayed by analysts as a crazy libertarian. A Milei win was almost unanimously seen as chaotic because his economic shock therapy would be too radical. What the consensus was not willing to explore was a pragmatic and successful Milei scenario. Again, we didn’t profess to have a view on the election results, but we recognised that a Milei victory combined with effective economic reforms was an overlooked scenario by market participants.
Generating alpha in EM Local Market Debt: a differentiated approach
EM Local Market Debt used to be dominated by global risk-on/risk-off factors. Accordingly, the first generation of investment processes were designed to analyse changes in global capital flows, while making forecasts on factors such as inflation and monetary policy. But times have changed. The share of foreign ownership in these increasingly fragmented markets has collapsed over the past decade, and most are now dominated by domestic investors with a very different set of regulatory constraints and views of the world. As market structures continue to be transformed, we believe that the traditional investment processes which could be relied upon to generate alpha are becoming obsolete. A Copernican Revolution is required, shifting the paradigm to a new generation of investment process.
With this in mind, our process is less concerned with analysing global capital flows or making valuation assumptions based on information that is widely available and well understood. Instead, we spend most of our time cracking open the ‘black boxes’ that are local market structures, assessing the constraints, biases and natural habitats of each constituent investor. We believe that what matters is not so much the next macroeconomic or political event, but how it could be perceived differently by global and domestic investors based on their expectations, biases and constraints. Such asymmetric interpretations of events can create distortions that we exploit to generate alpha.
To this end, we have developed quantitative and qualitative tools to analyse the liquidity of local commercial banks, as well as the regulatory constraints on domestic insurance companies and pension funds. In addition, we undertake in-depth analysis of global flows into local markets from dedicated EM investors, global fixed income investors and crossover investors. Finally, we assess potential policy changes around taxation and pension fund regulation that could have a material impact on the structure of domestic flows.
To visualise this theory with recent real-world examples, consider that EM local markets have performed well over the past two years against all odds. This may seem surprising, but not when shifts in fundamentals and market structures are taken into account.
Inflationary pressures were better contained in EM than in DM post-Covid, and EM central banks were the first to hike rates, especially in Latin America. This meant that policy credibility was actually stronger in EM. Despite significant outflows from foreigners, domestic investors were major buyers of local currency debt, which triggered an early normalisation of local curves. There was an initial disconnect between the reading of inflation risks among domestic and global investors, which could be exploited.
Moreover, given capital account restrictions and other regulatory constraints, readings of the risk-free rate were different among local and global players. For example, the risk-free rate for a local pension fund in Indonesia is not the US Treasury yield but the Indonesian curve. Against this backdrop, outflows from global investors were more than offset by a natural bid from domestic players.
Changing market structures can also have a significant impact on how an event or policy is assessed by market participants. A good example is how fiscal policies in Brazil were interpreted differently by domestic and global investors. The Lula election victory in late 2022 was initially seen as a positive by global investors, but their local counterparts were extremely concerned about a relaxation of fiscal policy and a resurgence of inflation. This tug of war explains why Brazilian local currency bonds started rallying only when domestic investor participation increased and economic policies became more credible domestically. The disconnect between how global and local investors interpret macro policies is a key source of alpha that we aim to capture.
Important information: This information is issued by TT International Asset Management Ltd (“TT”), authorised and regulated in the United Kingdom by the Financial Conduct Authority. This information is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. The circulation of this information is restricted to professional investors as defined in the legislation of the jurisdiction where this information is received. No representation is made as to the accuracy or completeness of any information contained herein, and the recipient accepts all risk in relying on this information for any purpose whatsoever. Without prejudice to the foregoing, any views expressed herein are the opinions of TT as of the date on which this information has been prepared and are subject to change at any time without notice. TT does not undertake to update this information. Any forward-looking statements herein are inherently subject to material business, economic and competitive risks and uncertainties, many of which are beyond TT’s control and are subject to change. The information herein does not constitute an offer of shares or units in any fund, and it is not an offer to, or solicitation of, any potential clients or investors for the provision by TT of investment management, advisory or any other comparable or related services. No statement in this information is or should be construed as investment, legal, or tax advice, nor is any statement an offer to sell, or a solicitation of an offer to buy, any security or other instrument, or an offer to arrange any transaction, or to enter into legal relations. This information expresses no views as to the suitability of the investments described herein to the individual circumstances of any recipient. Any person considering any investment should consult the offering documentation if and when is made available. Investments carries with it a high degree of risk. Past performance is not necessarily indicative of future results and investors may not retrieve their original investment.