The “xenophobia premium”

The fund’s main focus is on short-duration, hard-currency bonds issued by the companies and governments in emerging markets, although Marber believes much of this universe is better rated and economically stronger than many developed countries. This fundamental strategy accounts for 90–95% of the portfolio.

These bonds offer attractive risk-adjusted premia that stem from a longstanding anomaly. Although default rates in emerging-market countries have historically been lower than in developed markets, emerging-market hard-currency bonds (typically in US Dollars) offer higher yields.

Peter describes this as the “xenophobia premium” – the excess return that developed-world investors demand from emerging-market bonds versus similar rated bond in the US or Western Europe.

This reflects their longstanding anxiety about being exposed to emerging markets, which they still see as exotic, unpredictable and inherently risky.

Given the lower default rates in emerging markets, this anxiety is ill founded and irrational. But it’s persistent and powerful too. “It allows us to harness a bigger risk premium for our beta”, Peter says, “So that’s exactly what we aim to do” (3).

In this way, the fund offers its investors a credit arbitrage opportunity. The team then applies successive screens and a country model to whittle down the bond universe from over 2,000 to a pool of around 250 – which still allows the portfolio ample room for diversification. The country model draws also on environmental, social and governance (ESG) factors, which the team has been incorporating into the process for almost a decade.

Adding alpha

With the core portfolio invested, Peter and the team then look to add alpha in a wide variety of ways. Most bond managers aim to outperform by simply investing in high-yield or “junk’ bonds. But this is inherently risky as it rests on getting the individual bond selections right. Bond risks are skewed to the downside, as defaults can savagely slash returns.

Peter and the team take a very different approach. They consider anything that’s liquid or tradable in the emerging-markets universe, including derivatives, equities, local-currency bonds and long/short investing. And they try to make full use of these opportunities to access alpha and control volatility for an “all-weather” philosophy to add value in most market conditions.

Relative value

An important strategy here is relative value, sometimes referred to as “pairs trading” involving a long and corresponding short position. For example, if the team believed longer-dated local interest rates in an Asian country were falling faster than its shorter rates,  it might buy a local 10-year bond and hedge the currency risk by shorting a  2-year bond of issue – creating what bond traders call a “flattener.”

Another manifestation of relative value is in equities. Emerging-market equities are inherently volatile, so the team employs lots of hedges to take out those risks. By focusing on a few favoured companies and going short in others, the team can bring the volatility right down than looks more like bonds.

Relative-value strategies offer a very low-risk way to add alpha for clients. During the Covid crisis, the team made good returns from going long online retailers and short their offline equivalents, in both China and Brazil.

Technical tactics

A second alpha-seeking strategy is a technical approach. The team has two technical specialists who look for short-term trading opportunities. These might present themselves over a month, a week or even a single day. That contrasts with relative-value trades, which typically take time to mature.

The team looks at a variety of indicators to see who’s buying or selling what, as this creates short-term opportunities. Here again, the team can go both long and short. In 2020, the fund benefited from opportunistic positions in digital sectors and “reopening” plays in tourism and hospitality.

In addition to the structural credit premia tied to investor anxieties mentioned earlier, emerging-markets nervousness can often create short-term technical opportunities. When investors panic in emerging-markets, Marber notes, they tend to “sell now and think later.” This occurred in March 2020, as Covid struck, echoing the knee-jerk sell-offs of 2008 and 2011. These routs tend to be short-lived and create opportunities for cooler-headed strategies such as Aperture’s fund.

Special situations

Finally, there are special situations. These can arise from be country defaults – like that of Ecuador last year. When the oil price plummeted, Ecuador had to restructure its debt, which plunged from to less than 30 cents on the dollar. Peter and the team saw an opportunity for a significant return. The risk was very limited; following the default, there was little room for downside left (4).

Other opportunities arose in 2020 in high-yielding countries dependent on tourism, such as the Dominican Republic. Their bonds sold off heavily as the pandemic took hold. But that presented a forward-looking opportunity given the likely rebound as Covid abates. The team also bought longer-dated bonds in countries such as the Czech Republic when pandemic-prompted rate cuts looked imminent.

The outlook: same as it ever was?

After two years, Peter and the team are looking ahead with confidence. As the global economy recovers from Covid, a rally in emerging-market assets may be imminent; emerging markets tend to strengthen with commodity prices and global trade as the US dollar weakens. 

In any case, the structural opportunity underpinning the Fund’s core strategy looks set to persist, just as it has throughout Peter’s decades-long career.

Meanwhile, the flexibility of the Fund’s alpha-seeking strategies should stand it in good stead5.

“When you can go long or short in 75 countries,” says Peter, “there are always opportunities out there. Emerging markets have most of the world’s population and generate the lion’s share of its economic activity. So the biggest risk that I see in these markets is not investing in them.”