When it comes to emerging markets, index tracking can result in both increased risks and missed opportunities.
The notion that the “average” active manager routinely underperforms the index has encouraged many investors to gravitate toward passive investing over the last decade. However, passive investment does not work equally well across all asset classes. When it comes to investing in less efficient markets, such as emerging markets sovereign and local debt, there are several reasons index tracking often results in both increased risks and missed opportunities.
EM debt seems to be facing a new wave of challenges after rallying strongly following the initial onset of COVID, which led to steep declines across nearly all asset classes in early 2020. These include not only COVID-related disruptions, which have contributed to higher current inflation, but also regulatory crackdowns in China and the prospect of rising developed market rates. Year-to-date performance across both local debt and sovereign hard currency debt reflects this mounting uncertainty, with both asset classes down for the year at the index level.
However, as is often the case, index-level returns mask the tremendous diversity, complexity and significant dispersion in performance from issuer to issuer. Indeed, while broad market conditions for EM debt often drive returns in the short term, idiosyncratic country fundamentals ultimately drive prices and performance over the long run.