Investors considering passive investments into emerging market (EM) sovereign debt should carefully examine how to avoid excessive concentration risk as well as to reduce exposure to the most indebted sovereign. Investors need to know the differences between various EM sovereign debt indices, as these differences can affect performance.
At the current time, over half of EM hard currency debt originates from Russia, Brazil, Mexico, Venezuela, Turkey, Indonesia and China. Over the last decade, the debt of these countries provided on average a 0.24% monthly excess over duration neutral US treasuries – below the average return for all EM countries of 0.37%. So, increased exposure to less indebted sovereigns might be a good strategy.
A standard market-cap index makes the largest allocations to the most indebted nations rather than based on the size or performance of their economies. So, to diversify and avoid excessive concentration risk it’s a good idea to consider a country cap, making sure that a single issuer has no more than certain percentage of exposure.
When we looked at the performance of several major EM USD indices over 1-, 2- and 3-year horizons, all had robust performance with 3-year cumulative returns in the range of 22-25%. Of these, the Barclay’s index, with a 3% cap, performed best, with a cumulative difference of more than 250 basis points over 3 years – a good example of the “smart beta” effect.