Interview: Going with the Flows

Investor flows are the lifeblood of any market recovery, and this is no less true in the diverse spectrum of the emerging markets. Yacov Arnopolin, portfolio manager for GSAM’s Emerging Markets debt and currency team, has been tracking the tides and sees a positive turn thanks to a resilient strategic investor base.

Why are investor flows such a perennially hot topic in emerging markets debt?

We often get questions from investors concerning flows in and out of emerging markets debt. The typical narrative centers on the potential instability of “tourist money” that flooded the sector after the global financial crisis, seeking higher growth and an escape from the over-levered balance sheets of developed market countries.

We recognize this ‘push’—out of quantitative easing—and ‘pull’—to countries on a sounder financial footing— but the story is more nuanced. The 2010-12 period saw a surge of retail money into emerging market debt mutual funds (see Exhibit 1). This may have been in part a corollary of the excitement around emerging market equities, with some of the money finding its way into fixed income. But the charm of emerging markets seemingly turned to a curse in 2013 with the “taper tantrum,” and many retail investors started to exit.

How did outflows impact performance and what are the implications in a recovery?

It is difficult to pinpoint how the fluctuation of fund flows since 2013 has impacted sector performance. However, just as negative returns often lead to outflows, positive returns lead to retail inflows—which may exacerbate the price action both on the upside and the downside. Whatever the case, we have observed retail outflows in the US and Europe slowing to a trickle, and overall flows have turned positive year-to-date. This leads us to believe most of the money that wanted to rush for the exits has already done so.

If all flows aren’t equal, how do you differentiate between the “tourists” and more committed investors?

We consider inflows by investor type. Over the past several years we’re encouraged by the steady pace of investment via ‘strategic mandates,’ reflected in segregated account funding by institutional investors. We continue to see a steady flow of client inquiries and Requests for Proposals, and flows data (see chart) chime with our impression of a consistent, gradual ramp-up of exposure.

EXHIBIT 1: INSTITUTIONAL INVESTORS STILL MAKING STRATEGIC ALLOCATIONS TO EMERGING MARKETS DEBT

Source: JP Morgan, EPFR Global, Bloomberg, as of April 1, 2016.

This institutional investor base is a slow but steady growth area, in our view. While the protracted manager selection process makes it difficult for these accounts to respond quickly to market movements and engage in so-called “bottom fishing,” they are able to top up existing mandates as attractive opportunities arise. The constraint is that volatility may dissuade institutional investors, or their boards, from acting as contrarians and adding on weakness.

Why hasn’t volatility deterred institutional investors from allocating to emerging markets? And why aren’t they selling?

We see three potential explanations. The first has to do with the still-negligible levels of emerging markets exposure. Timing market entry has been tough, but many investors have simply been moving from a near-zero allocation to low single-digits as a first step to ramping up exposure. And while volatility may have prevented them from getting to their long-term allocation target, reasons to sell have also been scarce given the modest amounts invested in emerging markets as a percent of overall portfolios.

Second, one shouldn’t forget how material emerging markets have become. According to the International Monetary Fund, emerging and developing economies account for 61% of world GDP, and JP Morgan data suggest their share of world bond markets is around 30%-35%.

And third, for all the noise around emerging markets, investors in hard-currency sovereign debt have been rewarded for staying. JP Morgan’s EMBI Global Diversified index has posted only a single year of negative returns—2013—since the financial crisis, as a combination of carry and the rally in US Treasuries has helped offset spread widening. The index is up roughly 46% since the start of 2010—that’s excluding the 2008-09 sell-off and subsequent reversal—and has registered average annualized returns of around 6.5% in the intervening years.

We’ve touched on some of the macro factors guiding investment in emerging markets. How important is policy, in your view?

The spread of negative rates is the developed world is a major differentiating factor. According to the latest JP Morgan figures, 24% and 38% of securities in their benchmark developed market (GBI Global) and euro area (EMU) indices, respectively, have negative yields.

This is by no means the case in emerging markets. The only country with negative yields is the Czech Republic. This market closely tracks German Bunds given the perceived likelihood of Eurozone accession, but is not part of the emerging market indexes we follow. And in a yield-starved environment the contrast is compelling: at the end of February the yields on JP Morgan’s benchmark local and external emerging market debt indexes, the JP Morgan GBI EM Global Diversified Index and the J.P. Morgan EMBI Global Diversified Index, stood at 6.85% and 6.28%, respectively.