Index-based investing may be ill-suited to take advantage of inefficiencies in the space
Index-based investing is taking many areas of fund management by storm. But the popularity of such strategies doesn’t necessarily mean that they should be used in all cases — and that includes the emerging-market bond space.
“We see many factors unique to emerging markets … that bolster the case for active management in the sector,” analysts at PIMCO said in a recent note.
Focusing mainly on the JP Morgan GBI-EM Global Diversified Index (GBI-EM GD), they noted two structural sources of performance friction that index investment does not account for. First are complex tax rules that a number of EM countries impose on foreign investors to discourage hot money flows. The firm estimated that taxes can create between 13 and 40 bps of annual performance “drag”.
“While we have yet to see any active fund adopt a tax-adjusted benchmark, active managers can take advantage of tools that provide more tax-efficient exposure,” they said.
Secondly, index-based products must undergo periodic portfolio rebalancing; that’s typically a monthly exercise that involves taking on new eligible bonds and dropping holdings that no longer fit the index’s criteria. For a passive approach, that likely means trading many bonds at once, whether or not liquidity conditions are optimal.
They also pointed to opportunities to generate alpha in the EM bond markets aside from those involving currency or bond-market weighting decisions:
- Capital preservation – Certain developing markets still choose to use capital controls, creating a risk of their being removed from an EM index and foreign investors’ holdings being trapped onshore. Active managers, PIMCO argued, could assess the likelihood of such a move and either divest from the market or use offshore instruments instead.
- Market depth – Active managers with a patient pool of capital to deploy could determine how liquid different developing markets are. Finding less liquid — and potentially higher-yielding — bonds within local markets could provide small but consistent additions to alpha.
- Off-index opportunities – Managers that are willing to do the additional legwork necessary to access markets that index screens exclude or limit exposure to have a larger opportunity set, which could potentially pay off.
- Currency and rate exposures – Unlike active management, index-based strategies can’t separate the bond and currency risks. The ability to overweight one while underweighting the other can potentially be a source of alpha, particularly when the contributions to performance from the two components diverge significantly.