“We're developing new ways to actively create added value”

When Sjacco Schouten became head of Emerging Markets Debt (EMD) in 2018, the team had to address a number of challenges. Ongoing changes in clients' demands, a poor performance track record and a less than best-in-class ESG perspective all meant that the team has had to reinvent its EMD proposition. But Schouten thinks the changes are not over yet. "We will continue to see important shifts in this asset class. Local currency debt and emerging market private debt will become more important, and we will continue to develop new concepts for investing in EMD with an increased focus on sustainability."

The overhaul of the EMD proposition in the past few years has involved everything from the introduction of new processes, to changes in governance and a stronger focus on limiting drawdown risks. Besides that, the EMD team itself has changed in terms of composition, culture, and roles and responsibilities. "We have developed the flexibility and skillset to deal with near constant change, in the asset class itself and also in terms of client requests", says Schouten. "I think we've been successful in this. In any case, over the past few years, we have delivered on our promises to clients."

The performance of the asset class has fluctuated substantially over the past few years. What is your explanation for this?

"2022 was indeed an extremely negative year from a total return perspective, for both hard currency and local currency emerging market bonds. The main reasons were the strong interest rate increases in the US; a re-pricing of risk that caused spreads to increase; and the negative currency returns versus the US dollar. This means it is difficult for the asset class to attract new money. When US Treasuries are offering investors an almost risk-free and quite generous return of almost 4%, what’s the point of adding risk in the form of EMD? Dedicated money is expected to remain invested, but the underlying story currently just isn't strong enough to expect a great inflow of new money into the traditional EMD asset class. The exception to this could be investors looking for alternative investments in developing countries that can help to support sustainable developments."

What would be needed to change the outlook for this asset class?

"Actually, the picture for EM is starting to look better and in fact our performance in 2023 showed a complete turnaround. From a macro-economic perspective, we see that EM countries’ fiscal balances have strongly improved in recent years and their creditworthiness has stabilized. Also inflation has peaked, creating some room for central banks to lower interest rates. Some have done so already, although as long as US rates remain high, they can't do too much or their currencies may come under pressure. So the outlook for EM has already become somewhat more positive, but the key to real improvement is economic growth. If emerging markets can begin to significantly outgrow developed economies again, that will give returns a real boost. Whether or not they can, will depend, to some extent, on factors beyond their control ‒ geopolitics, commodity prices, interest rates and so on. There are signs that growth momentum in some emerging markets is picking up, which could result in EM growth exceeding that in developed markets. We're not convinced yet, but there are positive aspects to focus on."

How does the shift from active to index investing affect your investment strategy?

"That's indeed an important change that we're dealing with at the moment. We're developing new ways to actively create added value for our clients within an index mandate. Such mandates essentially expect us to track the return of a market index, but leave room to emphasize sustainability rather than just traditional alpha. So at the moment we are trying to construct a better index, one with a similar risk-return profile but with improvements in terms of responsible investing or ESG criteria. So there is still an active part in our investment strategy, even within our index mandates."

What are good examples of these new ways of actively adding value?

"There are several. One we recently implemented involves a replication of the market index via a rule-based methodology called ‘fundamental country weighting’. Country weighting in the market index is merely determined by the size of the national debt, which is not necessarily the best guidance for investing in a country. What we do instead is take into account a country's scores on a range of macro-economic factors, like fiscal and current account deficits, and ESG factors mainly related to good governance. These scores then determine country weights. The goal is replicate the risk-return profile of the market index, without actually buying the entire index and thus save on transaction costs while creating a higher quality portfolio from an ESG and macro-economic perspective. It's a balancing act that enables our clients to increase the responsible investment profile of their mandates, have more control of costs and obtain the returns they expect."

You said there were more examples?

"In addition to constructing new indexes there is also an active investment element in our portfolio composition. For example, we try to find alternatives to ordinary government bonds in local currencies that we would normally buy just because they're included in the index. Green bonds issued by that government could be such an alternative. So could bonds in the same currency but issued by Multilateral Development Banks (MDBs) or Development Finance Institutions (DFIs), for example the European Bank for Reconstruction and Development. Then instead of lending to a government we might not be entirely comfortable with from a governance perspective, we deal with a triple-A issuer with a much better ESG profile. So we still closely track the index, because we have the same currency and duration exposure. But we've also improved our portfolio profile from a responsible investment perspective, and on average still meet our return objectives."

In 2022 APG announced its first investment in ILX Management's new SDG-focused EM Private Loan fund. You were quoted then as saying that funds like these would "unlock a new universe of responsible investment opportunities in the private credit space." What has happened since then?

"A big part of the EMD universe is made up of government bonds that don't target specific SDGs let alone qualify as impact investing. And although emerging countries have issued more green or labeled bonds in recent years, the total volume is still very limited. Our investment in the ILX fund marked our first step into private debt, through loans originated by MDBs and DFIs such as IFC, EBRD, the African or Asian Development Banks or the Dutch Entrepreneurial Development Bank, FMO. So the ILX fund provides access to an asset class which is a welcome addition to the EMD universe for investors like us and for our clients who want to have more impact. Projects that are financed by this fund aim to deliver a direct and measurable positive impact on their environment by targeting one or more SDGs. The loans are used for example to support sustainable fishery in Turkey, a Chilean energy company that is transferring to renewables, and initiatives to increase the participation of women in business. The bottom line is that we can't have Paris alignment without emerging countries, and a lot of capital will be needed to achieve this. So I think EMD can make a great contribution to achieving climate goals and other SDGs. My expectation, and certainly my hope, is that the importance of this asset class will increase substantially."