Kheng-Siang Ng

More than 20 years have passed since the Asian financial crisis and we have seen the region’s local-currency bond market grow from $304 billion in 1998, to over $12 trillion in value today. This rapid ascent can be traced back to programmes such as the Asia Bond Fund (ABF) initiative developed post-1997, as a collaborative effort by the central banks in the Asia Pacific region, to encourage the development of local bond markets. These efforts aimed to curtail reliance on overseas funding capital and to tap into the region’s wealth as a way of insulating it from future economic shocks.

Of course, any government’s efforts would have been futile if investors had failed to participate, but the region’s favourable growth characteristics; a reduction in credit risk (as well evident in the upgrades of a number of Asian countries’ sovereign credit ratings over the past years); the prospect of relatively higher yields; and the benefits of portfolio diversification have all worked in tandem with these coordinated policies and have contributed to a boom in local bond markets.

DIRECT INVESTMENTS, MANAGED FUNDS AND ETFs

Having decided to include an allocation of funds towards local currency bonds, investors are faced with two choices – should they invest in individual bonds or opt for a collective vehicle, such as a managed fund or an exchange-traded fund (ETF)?

If an investor has access to comprehensive and timely bond market research, direct investments would appear attractive as they can hand pick bonds that best complement their existing portfolio or those in which they have the most confidence.

This process takes time and requires skill and effort in researching individual bonds. So it’s not surprising that many investors, big and small, turn to external managers who have the capability and resources to identify individual bond opportunities, and who monitor markets closely, seeking changes in interest rates or currency movements and understand how these factors will impact bond performance.

ACTIVE MANAGERS STRUGGLE TO OUTPERFORM

In the past, adopting an active management approach was perceived to be the best way to invest in emerging markets debts (EMD), including Asian bonds, based on the assumptions that EMD is an inefficient market and there are some obvious weak segments that could be avoided by active management.

The reality is, however, very different. The majority of active managers fail to outperform their benchmarks over the longer term.

State Street Global Advisors has carried out a comprehensive study of the active managers in the Morningstar database tracking two flagship EMD indices: JPM GBI-EM Global Diversified Index (GBI-EM) for local currency, and JPM EMBI Global Diversified Index (EMBI) for hard currency.

According to our study, in the hard currency sovereign universe, 50% of active managers underperformed their benchmarks in a one-year period. Even more – 57% and 83% respectively – failed to outperform over three and five years1. Outperforming the benchmark seems to be even more challenging for active managers in the local currency universe, with 80%, 83% and 87% of active managers failing to outperform their benchmarks over one, three and five years1.

There is also some semblance of a correlation between market underperformance and active manager underperformance. This is especially the case in local currency where it often appears that the worse the index performs, the higher the percentage of active managers who underperform.

The inherently volatile nature of the EMD sector is likely to be one of the key causes of active manager underperformance. Returns are often misaligned with fundamentals, as they are driven by investor sentiment and political risk, which are harder to predict and often lead to binary outcomes.

THE RISE OF INDEXING

Indeed, most assets in the Asian local currency fixed income space remain in managed funds. But the markets now offer much greater liquidity and diversity. More cost-efficient and transparent index approaches, in particular ETFs, are increasingly being seen as highly effective and are gaining popularity among investors.

ETFs offer a number of benefits to Asian fixed income investors. Because of their index-tracking structure, ETFs are generally cheaper to run than managed funds. This will, in turn, positively influence the fund’s overall return.

Trading like stocks on stock exchanges also allows quick and easy access to Asian local currency bonds, saving the hassle of dealing with many local bond market account opening and tax matters, as well as the hassle of executing bonds and foreign exchanges with different market hours and settlement practices.

ETFs can appeal to investors who wish to play an active role in the management of their money. Its liquidity access via primary and secondary markets and the flexibility in trading helps facilitate tactical and strategic asset allocation decisions.

Visit www.abf-paif.com* for our latest insights and investment ideas for Asian fixed income.

1 Source: Morningstar. The universe is generated by selecting the 30 largest live funds as of 31 May 2018.

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