Pramol Dhawan on incorporating downside protection in Emerging Market investing
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The global financial order is evolving. Rising interest rates and global supply chain shifts are causing many investors to recalibrate their portfolios and look to new markets for returns.
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Whilst emerging markets present opportunities to investors, they have historically been associated with high levels of market volatility. However, the development of financial systems across emerging economies means there are now a variety of regional opportunities that can be harnessed with active investment approaches.
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Focus is a publication that aims to bring you face-to-face with a selection of key investment managers, advisers and providers from across the institutional pensions market.
In this guide, PIMCO explores the landscape of emerging markets and explains how it has developed approaches that enable investors to access opportunities in the asset class, while seeking to guard against market volatility.
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Risk factors you should consider before investing: • This material is not intended to provide investment advice or be considered a personal recommendation. • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. • Past results are not a guide to future results. • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful. • Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems. This material, issued by Capital International Management Company Sàrl (“CIMC”), 37A avenue J.F. Kennedy, L-1855 Luxembourg, is distributed for information purposes only. CIMC is regulated by the Commission de Surveillance du Secteur Financier (“CSSF” – Financial Regulator of Luxembourg) and is a subsidiary of the Capital Group Companies, Inc. (Capital Group), also authorised and regulated in the UK by the Financial Conduct Authority. While Capital Group uses reasonable efforts to obtain information from third-party sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice. © 2022 Capital Group. All rights reserved.
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THE INTERVIEW
Name xxxxxx xxxx xxxxx xxxxxxx
Pramol Dhawan, Head of Emerging Markets Portfolio Management at PIMCO, explores the evolution of markets and how PIMCO’s Emerging Markets Opportunities Fund (EMOF) looks to harness opportunities while mitigating downside potential.
emerging markets have reduced vulnerabilities in their financial systems and the area now rewards those investors with a more nuanced approach.
nvesting in emerging markets (EM) has historically been associated with high risk and high reward. The asset class has always had the potential to outperform developed markets, but also carried significant downside potential. However, today, some
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The growing nuance of
Over the past twenty years, emerging market countries have addressed many of the vulnerabilities that have deterred foreign investors. Dhawan explains that many countries have built up their U.S. dollar assets and further developed local bond markets. They have also localised their current accounts and allowed for free movement of money.
He says: “All these factors have created a more investable climate for foreign investors. Whether they choose to or not, it’s a lot easier for people to invest with confidence now than it was 20 years ago.”
Emerging markets is an asset class that naturally lends itself to active management. The investing environment is very costly to replicate in passive strategies that struggle to take advantage of inefficiencies in the market. An active manager can have more nuanced processes that adjust for the costs present in the index, including capital gains and withholding taxes as well as transaction costs.
Working together
Dhawan explains that PIMCO uses a proprietary beta enhancement process that reduces much of the cost and gives PIMCO’s emerging market strategies a competitive advantage over passive vehicles, as well as other active managers.
He highlights that emerging markets are still a maturing asset class ripe for arbitrage opportunities and other ways to outperform the index. This involves finding instruments with better value. This can include moving between cash and derivatives products as well as between local and external markets. There are also opportunities to capitalise on slower-moving trends and investors crossing over in the asset class.
has helped drive risk asset valuations ever higher despite the damage wrought by COVID-19, compressing yields and making portfolio income distribution objectives harder to achieve in both equities and fixed income.
He says: “You have this rich tapestry of opportunities whereby if you are thoughtful, structured and somewhat systematic in your approach, you can structurally add value as an active manager without taking too many large bets.”
The growing nuance and breadth of opportunities in emerging markets means that investors no longer need to adopt a high-risk, high-reward approach. As the asset class matures, it can increasingly be treated as part of an investor’s broader investment strategy, providing a diversified source of returns within a portfolio.
Dhawan concludes: “I think that gets to the crux of what we’re trying to do here. We build up stable value propositions so that, even if there is a significant shock, you are still going to be regional within your investment selection.”
As a result of the changing landscape, investing has become more nuanced. While in previous cycles, investors would allocate to emerging markets when they began outperforming developed markets, today they look more closely at EM valuations.
Pramol Dhawan, Head of Emerging Markets Portfolio Management, PIMCO
As a result of the changing landscape, investing has become more nuanced
Those numbers are climbing as investors, shunning both falling equity and bond markets, stockpile cash for its haven appeal. In its latest monthly investors survey, Bank of America described the current mood as “extremely bearish” and found the highest allocations to cash since 9/11.
Gary Kirk, co-manager, TwentyFour Sustainable Multi Sector Credit Fund
ESG will drive asset performance, particularly among institutions that have to stand up and be accountable to their members
He believes that from an adviser’s point of view, there is a large opportunity to broaden the focus and think of cash as a strategic asset class and part of a holistic, diversified portfolio.
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Emerging Market investing
In an increasingly fragmented world, how do you sort the winners from losers in emerging markets?
All these factors have created a more investable climate for foreign investors
Some emerging market assets can provide the compensation you would typically associate with riskier credits – despite the risk of default remaining small – and this risk premium can be highly attractive for emerging market investors.
Dhawan says: “We think that for longer-term investors who are willing to hold onto assets through the noise, they are effectively getting in at levels where they can potentially be well compensated from a future return perspective.”
Rising interest rates also offer an opportunity for investors, certainly for those with a historical home bias. For example, over the past 10 years, the strengthening of the pound sterling versus a number of emerging market currencies has rewarded UK based investors who have invested close to home. However, with several central banks starting to raise rates in a historically low interest rate environment, local emerging market currencies can provide opportunities for investors looking to recalibrate their portfolios.
The Active Opportunity
You can structurally add value as an active manager without taking too many large bets
In-DEPTH Q&A
FUND SNAPSHOT
The growing nuance of Emerging Market investing
PIMCO GIS Emerging Markets Opportunities Fund
Augmenting yield and adding downside protection through:
Reconstructing the EM risk profile (~35% of returns)
Market outlook
Integrating ESG:
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• Smart beta replication • Additional convexity • Tail-risk hedging
EMOF’s Portfolio Construction Framework
Going beyond just asset allocation
Select a circle for details
Dynamic value tilts across the main risk factors in the asset class, including:
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Active allocation across hard and local currency (~20% of returns)
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Sovereign versus quasi-sovereign versus corporate spreads Interest rates Currencies Country by country
Beta-neutral positions with high sharpe ratios, including:
Alpha overlay (~45% of returns)
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New issue premiums Relative value, paired trades Bespoke investment opportunities
As of 31 December 2021. Source: PIMCO.
A comprehensive allocation to PIMCO’s best ideas in emerging market debt
EMOF: A better blend
Constructed from the full spectrum of opportunities, including hard currency, local currency, and corporate debt
An optimized blend
A full expression of the team’s best ideas, expressed through its “bend don’t break” approach
PIMCO’s EM flagship
A smoother journey, with less downside and a higher sharpe ratio
Explicit downside protection
Institutional (INST - Acc share class), Accumulation Shares
PIMCO GIS Emerging Markets Opportunities Fund: 12-month rolling performance
Past performance does not predict future returns.
As of 31 July 2022. Source: PIMCO. The Fund is actively managed in reference to an equally weighted blend of the J.P. Morgan Emerging Markets Bond Index Global (EMBIG) EUR Hedged and the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified (GBI-EM Global Diversified) EUR Unhedged as further outlined in the prospectus and key investor information document. * Index is shown for performance comparison purposes only. Index: 50% JPM EMBI Global (EUR Hedged) / 50% JPM GBI-EM Global Diversified (EUR Unhedged). All periods longer than one year are annualized.
A better blend
EMOF portfolio positioning & statistics
Historical allocation to external vs. local debt
Historical allocation to sovereigns, quasi sovereigns and corporates
Historical allocation to external vs. local currencies
Top country exposures (DWE)
0.50
0.38
0.22
0.19
0.17
0.15
As of 31 July 2022. Source: PIMCO. For illustrative purposes only. Refer to Appendix for additional model portfolio, investment strategy and risk information.
Performance since inception
Delivering market-beating returns while mitigating the downside
As of 31 July 2022. Source: PIMCO. *Since Fund Inception on 04 June 2019. The Fund is actively managed in reference to an equally weighted blend of the J.P. Morgan Emerging Markets Bond Index Global (EMBIG) EUR Hedged and the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified (GBI-EM Global Diversified) EUR Unhedged as further outlined in the prospectus and key investor information document. Emerging Markets Risk: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk. Investments in these markets may expose the fund to larger gains or losses.
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As of 31 July 2022. Source: PIMCO. For illustrative purposes only. Refer to Appendix for additional model portfolio. investment strategy and risk information.
How PIMCO’s Emerging Markets Opportunities Fund creates downside protection
In-Depth Q&A
Platform snapshot
What we do is give clients a smoother journey in this asset class
We have a great reputational advantage with these issuers, which recognise us as being long-term and flexible investors
We have just passed the three-year anniversary of the PIMCO GIS Emerging Markets Opportunities Fund. We try to take a holistic look at the asset class and create a product exposure which serves two purposes.
Firstly, delivering the best of what PIMCO can do for clients in one flagship product. The second is to capitalise on what we call the negative convexity of this asset class – the fact that it tends to draw down quite a lot.
Many clients are wary of being long-term holders due to the higher volatility associated with emerging markets. What we do is give clients a smoother journey in this asset class, to have embedded downside protection that can outperform when markets are down and utilises the best of what PIMCO can provide.
First and foremost, it’s a blended product. Our traditional emerging markets products are single-beta strategies where clients choose their risk exposure. This fund has a go-anywhere strategy. It’s flexible and the allocation is done for the client. It’s going to be high conviction and protect on the downside.
To achieve that from a portfolio construction perspective we have three parts. The first part is reconstructing the risk profile. We utilise all our in-house proprietary smart beta tools and use derivatives as well as bonds to gain the most efficient market exposure.
The third part is our alpha overlay. This is the engine that drives the excess return that allows us to keep up in robust markets whilst maintaining low risk.
Emerging markets is an asset class where size and scale matters. At PIMCO, it is a major competitive advantage. Not only do we have one of the largest teams in the industry, we are also often one of the largest owners – if not the largest owner – of all of the names within the index, in either local or hard currency.
We have a great reputational advantage with these issuers, which recognise us as being long-term and flexible investors. They know they can come to us and trust we will provide solutions.
Size matters because one of the most sustainable ways to generate returns is to harvest new issue premiums. By virtue of us being one of the largest, if not the largest player, in this market, we are able to consistently approach issuers and maintain very high allocations to new issues.
How does the size and global nature of your team contribute to the performance of the fund?
Equally, it can complement existing exposures. If clients want to dial down the volatility from other exposures but maintain their overall allocation, this is a fund that can be used from that perspective.
It has been a tough year for the asset class. It has been the largest year for outflows on record, but PIMCO delivered positive results with $2.7billion net new inflows.* We see this as a vote of confidence in our process, reinforcing the view that PIMCO is a safe pair of hands when it comes to investing.
Pramol Dhawan, Head of Emerging Markets Portfolio Management, explains how his team develop global emerging market exposures with downside protection
Why and when was EMOF launched?
What differentiates this fund from traditional benchmark emerging market products?
The second part is an active allocation between local and hard currency. The fund itself is not tied to this 50:50 exposure; we can look to recreate a dynamic mix of hard currency and local currency exposures with the proportions depending on the expected returns.
To give you an example, in the past we worked in collaboration with a Caribbean country that was looking to create and establish foreign investment in its local bond markets. That opened the way for more foreign investment into that country.
Our globally distributed team also has specialists in each of these countries – if there are problems, we are going to be among the first to understand and help our clients.
This is a vehicle for both retail and institutional clients. If you are interested in taking advantage of the vast EM opportunity set, then this fund is an interesting solution, as a go-anywhere vehicle. It has the flexibility to move between local and external currencies and debt, and to capitalise on arbitrage opportunities. It can be a go-to fund for broad global emerging market exposure.
Who is this fund for?
