A weaker dollar may have held back returns for unhedged overseas investors in the S&P 500 this year, but there’s always some up on the downside to be had.
Funds invested in local currency emerging market debt have widely benefited from Trump’s ‘America First’ policies that have brought the greenback back down to earth. The dollar index, which measures the performance of America’s currency against a basket of peers, has fallen almost 10 per cent year-to-date, which tends to spell good news for emerging markets.
The investment case for emerging market debt, however, splits opinion among our allocators. Of the 54 DFMs we cover, 25 of those use EMD in some form — though the average overall weighting stands at just 2 per cent.
Within the camp that favours it, there’s a debate as to whether this particular brand of fixed income operates best as a short-term, tactical exposure or whether it deserves a more permanent place as part of a portfolio’s strategic asset allocation.
The team at Invesco certainly believes the long-term merits of holding EMD are often overlooked, with diversification away from mounting debt dilemmas in developed markets a key benefit.
“At current yields, it offers a compelling source of alternative income, particularly should traditionally safe haven fixed-income assets begin to be considered less ‘risk-free’ due to rising fiscal deficits and a mounting debt burden,” said David Aujla, portfolio manager at Invesco.
Ditto for Aberdeen, who describe themselves as ‘long-term’ holders of the asset class.
“As global growth rebalances and monetary easing accelerates outside the US, EMD has been in a bit of a sweet spot,” said Jason Day, senior MPS investment manager at Aberdeen.
“Emerging market inflation has largely normalised to pre-pandemic levels, enabling continued rate cuts and easing monetary conditions, while pronounced US dollar weakness has provided further support for local currency debt.”
AJ Bell holds up to 6 of their portfolios in EM debt, and they also take the view that the asset class diversifies at a time when plenty of questions are being asked about longer-duration gilts and US Treasuries. They told Asset Allocator that they don’t envisage changing that stance through the remainder of the year.
How best to get this exposure, then? Some allocators favour the blended approach, whereby a fund’s assets are split between local currency and USD-denominated debt.
“The two types of bonds can be very different in their return profile,” said Sam Hannon, investment manager at 7IM. “The returns of the local currency bonds can be heavily driven by the foreign exchange component, which can override the interest earned on the bond due to the volatility of the currency. For dollar-denominated bonds, that forex component is stripped out and therefore most of the return is driven by the risk of the country that has issued the bond.”
7IM holds the Capital Group EM debt fund and the Barings Emerging Market Blended debt fund, both of which held an overweight to the Brazilian Real which benefited from forex intervention and nearly 300 bps of rate hikes, which allowed it to recoup the losses from a poor 2024, he added.
Another fund that’s proved particularly popular among the DFMs we cover is the M&G Emerging Markets debt fund, held by a whopping 12 allocators, according to our database records.
Marlborough is a holder of the fund, and their head of investments in multi-asset Raj Manon said that the fund’s returns this year have very much depended on whether investors hold the share class that’s hedged back to sterling or not.
The hedged share class has returned around 9 per cent year to date, while the unhedged share class has returned around 3 per cent. Fortunately for Marlborough, they do hold it in sterling.
He also expressed confidence in the fund’s new management structure following the retirement of Claudia Calich, which can so often prompt fund buyers to take stock.
“We’re pleased to see continuity in the investment process and philosophy she championed,” he said.