Reassessing the allure of emerging market debt

Within multi-asset, risk-based funds are proving increasingly popular, particularly after the Retail Distribution Review, as a way to provide investors with a level of return in line with their attitude to risk.

Risk-based funds have an increasingly wide range of investible assets to choose from and can use strategic asset allocation models to create specific risk-reward portfolios. This requires a detailed understanding of how each asset class is expected to behave over time and the correlation with other asset classes. The ultimate aim is to generate the highest level of return for each level of risk.

However, it is important for managers to remember that as macroeconomic events unfold over time, the risk profile of portfolios can change if the asset allocation is not rebalanced. Portfolios with a broadly static asset allocation will be exposed to ‘risk drift’.

It is important to review the asset allocation every quarter to ensure continued delivery of the risk and performance profile expected.

The current environment is a favourable one for risk assets, specifically developed market rather than emerging market equities. With inflation still muted across most developed markets, central banks are under little pressure to tighten monetary policy quickly. However, the strong growth seen in the UK and US means the Bank of England and Federal Reserve are likely to be the first to act.

Central bank policy in both Japan and Europe remains unambiguously committed to stimulating growth and this support is likely to remain in place for at least the next year.

There is an obvious requirement to carefully monitor this position for any increase in geopolitical risk from Russia or the Middle East, or signs of earnings disappointments, both of which could cause valuations to start to look stretched.

In spite of the benefits of developed market equities, the strong fundamentals of many emerging market equities are widely recognised. Many emerging market companies are likely to be the leaders of the future and are increasingly establishing themselves as global winners irrespective of their sector.

But there are concerns. For example, growth in China and Russia is slowing, Brazil has slipped into recession and India faces a serious agenda of reforms, among others.

Therefore, with the tapering-induced volatility of 2013 and early 2014 seemingly behind it, emerging market debt now appears more attractive, especially as some of the key risks look to have diminished.

As a result, the available yield on the asset class stacks up well relative to investment-grade and high-yield bonds, both of which have experienced significant credit spread tightening year to date.

The key to managing multi-asset funds with clearly defined risk-return profiles is to ensure that both long-term strategic and short-term tactical asset allocation strategies remain flexible.

Investors should then be assured that their chosen level of risk will remain constant during the period of investment and if correctly managed should lead to performance commensurate with the risk chosen.

Bambos Hambi is head of fund-of-funds­ ­­management for Standard Life Investments