EM debt offering less diversification potential

Investors need to be wary of “diversification decay” in emerging market (EM) portfolios, as the asset class’s index risk becomes more like systemic, developed-markets risk.

Increased EM debt holdings by institutional investors, index-based EM portfolios, and more risk-off/risk-on episodes over the last decade had sparked this change in index risk.

As many EM debt investors invested in the asset class to seek exposure that differed to that of developed markets, they needed to ensure they were mitigating the impact of the change.

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“We believe [diversification decay] can be largely avoided through active strategies that focus on country-level macroeconomic and political research, and standalone analysis of specific risk factors such as currency, credit spreads and interest rates,” a spokesperson for the debt team at Eaton Vance said.

“Standing apart from the indexation herd in this fashion through active strategies … can potentially preserve the important diversification benefit of EM debt investing.

“Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, currency exchange rates or other conditions. In emerging or frontier countries, these risks may be more significant.”

Eaton Vance noted that such decay was a “growing problem” was portfolios tied to the JPMorgan Government Bonds Index – Emerging Markets in particular.

The chart below showed how, for the 19 currencies tracked by the index, correlations with global high-yield debt increased significantly during the GFC and had remained elevated since. Correlations of off-benchmark currencies however, advanced only slightly and remained lower.

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