Investors and portfolio managers live and breathe index. In the emerging market bond universe, JP Morgan’s Emerging Market Bond Index Global Diversified (EMBI GD), composed of government bonds denominated in hard currencies, the Corporate EMBI Broad Diversified Index (CEMBI), for corporate bonds in hard currencies, and GBI-EM Global Diversified Index for government bonds in local currencies, are the most widely tracked.
Of the three, the hard currency indexes tend to get the most attention, with passive portfolio managers working diligently to – as best they can – replicate exposure of the indices they track and active investors constantly tweaking their allocations (diverging from the benchmark) in the hunt for more yield.
The problem is these indices reflect an astonishingly small percentage of the asset classes they purport to reflect. Of the more than US$18.5tn in emerging market fixed income assets that exist globally, just 8% are tracked by index providers (which are typically investment banks), according to data collected by Ashmore Investment Managers, an asset management firm specialising in emerging markets.
Hard currency sovereign debt, probably the most widely tracked by EM fixed income investors – and, one would assume, sees strong representation in global bond indices as a result, also fell short, with just under half (48%) of the US$835bn asset class captured by global index providers.
The discrepancy is particularly acute with local currency debt. Just 9% of emerging market local currency government debt is covered by index trackers. For local currency corporate debt, that figure drops to 2%.
That said, index builders – investment banks for the most part – do have their reasons for exclusion. More often than not, however, it depends on whether an investment bank trades those assets themselves, which in itself, as Jan Dehn, Head of Research at Ashmore points out, represents basic market failure.
“[I]f the investment bank does not have a market making operation in a particular EM country then that market will quite simply not be covered. This is a pure business decision on the part of the banks: as long as the bank trades the market in question the index groups can get free daily pricing data. There is no appetite to provide index coverage for markets that the bank does not trade, since the index group would have to buy the pricing data without the means to recoup the cost through trading operations,” Dehn wrote in a recent research note.
Closely linked with that is the state of the regulatory environment in EM countries and the level of liquidity with respect to the assets in question: How easy is it to buy and sell those assets? How much legal and regulatory clarity are investors afforded? How exposed is the securities market – and its main arteries – to the capriciousness of regulators? And so forth. Fair enough – after all, index builders need to maintain some kind of floor when it comes to the friction generated from market entry and exit.
But the divergence between the state of EM asset classes and the benchmarks that track them are becoming harder to justify, as highlighted by the recent addition of onshore Chinese government bonds and the bonds of three large Chinese state-backed lenders to a parallel version of the Bloomberg Barclays Global Aggregate Index – up to US$2.5tn worth, representing more than 5% of the index.
Barclays was following Citigroup, which in March this year became the first major index provider to include onshore Chinese bonds in several indices including the Emerging Markets Government Bond Index, where the share of Chinese onshore government bonds is being scaled up to nearly 5%. JP Morgan includes about US$575bn worth of Chinese government bonds in its emerging market local debt index family, though none of them qualify for inclusion in investable benchmarks.
Despite index builders’ reasoning, the fact that the world’s third largest bond market is scarcely to be found in global benchmarks is hard to fathom. Global investors hold less than 2% of outstanding local currency government securities, in large part because of massive underrepresentation in global indices.
ETFs on the Rise
In theory, if China were included in JP Morgan’s GBI-EM uncapped index, it would account for close to 35% of it; in reality, it would likely be added to the capped fund and limited to a much lower percentage, but this goes to show just how dislocated the world of indices can be from the asset class as a whole.
This has a number of implications – for the emerging market investment community in particular, the wider business of indexing as well, and to some extent, to global financial stability.
Largely due to a longstanding deficit of credible information and data, active portfolio management was historically a more popular approach in emerging market investing, but improved automation coupled with significant pressure to expand low-margin retail investment products like exchange traded funds, many of which simply replicate existing indices, means this is changing – and fast. During the emerging market rally of March/April 2016, for instance, when EM bonds saw close to US$10bn in net inflows, well over a third went into ETFs, an impressive feat for a product that barely existed 10 years ago.
At the heart of these approaches and products is, you guessed it, the almighty index: a guiding light and a benchmark for both individual portfolio managers’ performance and that of the wider market. But given the reasoning alluded to above, it becomes increasingly difficult to gauge the performance of a portfolio manager or a fund, let alone the ‘true’ performance of an asset class – the former posing a particular problem for active portfolio managers and the latter a problem for pretty much anyone with a stake in price transparency as a reflection of real capital flows.
In practice, exclusion actually translates into fewer opportunities for asset diversification, creates a drag on market efficiency, and makes it more difficult to boost liquidity within the EM asset class (the converse would lead to the opposite in most cases).
But it also beckons important questions about indexes more broadly. Market distortions caused by incomplete or scarce pricing information has the potential to create – and indeed has already contributed to – wild swings in capital flows.
One could make the argument that capitalising off these market inefficiencies is exactly what investors are tasked with doing, which is a fair point, but only to the extent that it doesn’t threaten financial stability. This could mean a drastic change in the how indices are constructed – and more crucially, who constructs them.