How good is IPE MBA
Following the recent widening of spreads, emerging market debt offers an interesting risk / return profile. IPE D.A.CH editor-in-chief Frank Schnattinger spoke to Dr. Markus Ploner, CFA, MBA, Managing Director, and Mag. Franz Schardax MSc, Spängler IQAM Invest, on the advantages of factor investing in emerging markets local currency bonds and the further prospects for emerging countries.
IPE D.A.CH: Many institutional investors are still shrinking from EM local currency bonds. Is this asset class really that volatile?
Ploner: The turbulence has increased sharply across all asset classes in recent months. Nonetheless, viewed over a longer period of time, one has to state that EM local currency bonds perform significantly better than stocks on issues such as volatility and maximum drawdown. The recovery time to a new high is also significantly shorter than that of global stocks and even euro government bonds.
IPE D.A.CH: You use a factor-based approach to the asset class. How did that happen?
Schardax: I admit that it is quite unusual for the asset class to work with a factor approach. However, experience since the approach was developed for this asset class in 2013 has shown that, if applied consistently, it can lead to very good results for our investors.
IPE D.A.CH: Which factors then proved to be stable in the long term?
Schardax: We are talking about three variables here: the interest rate differential, i.e. the 1-month forward exchange rate divided by the spot exchange rate - the real exchange rate, in our strategy the difference between the current value and the 6-year average - and the credit default swap , here too the difference between the current value and the 6-year average.
IPE D.A.CH: How do you then put these building blocks together?
Schardax: Our optimization algorithm looks for a portfolio with an optimum of risk-adjusted returns for a rolling 4-year time window. The weighting of the factors is determined accordingly to the market environment and adjusted in the portfolio.
IPE D.A.CH: How do you come up with the respective country weighting?
Schardax: Based on the respective initial weights of the individual countries, we multiply the optimized factor weights by the corresponding factor values and you get the optimized country weights.
IPE D.A.CH: How often do you rebalance the portfolio and how do you avoid high transaction costs due to heavy reallocations?
Schardax: We adjust the portfolio on a monthly basis and have indeed built in a kind of transaction cost brake by preventing excessive shifts. Experience has shown here that transaction costs in the emerging markets overcompensate for any added value.
IPE D.A.CH: How has the importance of the individual factors shifted in recent years?
Schardax: Until the 2008 financial crisis, the interest rate differential factor had a major impact, up to 75% - it was the heyday of carry trades. This influence has gradually decreased, the real exchange rate and the credit default swap rate have become more and more important.
IPE D.A.CH: What are the results so far?
Schardax: We started the portfolio in July 2014 and over time have managed to beat the benchmark by around 50 basis points per year. The return after costs is 2.13% p.a. If I may add, our peer group was 0.33% p.a. during this period.
IPE D.A.CH: You recently integrated another factor into your strategy, what is the background?
Schardax: We have seen that since the Taper Tantrum in 2013 there have been more and more severe losses in individual markets, which can amount to 15% and more over a period of three months. So in our last evaluation we came up with a factor that we call the overheating indicator. We are referring to the sum of inflation and the current account balance. For example, rising inflation and a rising current account deficit indicate overheating tendencies, where bonds from the corresponding countries usually show a clear correction as a result. In the back calculation of our model, we recognized that the contribution from this factor has become quite significant over the past few years. We have now actively implemented it for the first time in the May 2020 allocation.
IPE D.A.CH: How exactly does it affect the portfolio?
Schardax: It significantly improves the risk / return ratio. The return changes only marginally, but we see a significant decrease in risk, by almost a third.
IPE D.A.CH: If I have understood correctly, the revision in May not only added a new factor but also a second one with sustainability ...
Ploner: At Spängler IQAM, we have set ourselves the requirement that all mutual funds in 2020 reflect the sustainability concept. In the case of an emerging markets product, this is not necessarily easy to implement, but I am convinced that we have solved this well with a minimum threshold for the sustainability score of the portfolio compared to the benchmark. We want to be at least 20% better than the reference index and use the ratings of the country model for government bonds by the rating agency rfu. Their scoring scale for individual countries is between -10 and +10, we make sure that we are always at least 0.2 or 20% better than the benchmark.
IPE D.A.CH: Finally, let's take a look at the future. Where do you see the EMD asset class after the "Corona correction"?
Schardax: Experience in the emerging markets shows that after a negative 1-year return, a strong rebound sets in in the vast majority of cases. Since the correction has brought the spreads to a very attractive level of up to 500 basis points for local currency bonds, I see very attractive prospects. Then there are the currencies that have even reached a 17-year low and also offer potential.
IPE D.A.CH: Thank you for the insight!
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