Q: What core beliefs or principles guide your investment philosophy?
A : Our general view is that long-term economic growth is fostered by broad application of liberal, free market social and economic policies. We believe that stability in the rule of law, relatively low and flat taxes, non-profligate monetary policy, and fiscal responsibility are some of the key policies governments should have in place.
Responsible governments that create an economic climate that expands the economy will also attract capital and offer higher returns.
Q: How do you formulate your investment strategy?
A : Our strategy seeks total return by trying to outperform our benchmark. Basically, we build off our benchmark and will go overweight or underweight countries based our views developed through our global research process. However, an important aspect is that we will invest in countries not included in the benchmark and we have the ability to outright short assets that we think are overvalued. This is an important part of our strategy and gives us flexibility.
It is designed to take advantage of fixed income and currency opportunities overseas. The fund has significant exposure to foreign currencies so that investors can potentially take advantage of declines in the U.S. dollar.
Q: What is your definition of emerging markets?
A : For the purposes of our mutual fund prospectus we defined emerging market countries as countries that did not become a member of the Organization for Economic Cooperation and Development (O.E.C.D.) prior to 1975, and Turkey. However, they are typically thought of as countries where political and macroeconomic environment are frequently changing and have a significant impact on capital markets. Emerging market countries are either comparatively underdeveloped or in the process of becoming developed. Furthermore, these countries may have relatively unstable governments and economies based on only a few industries.
Q: How is investing in emerging markets different from investing in the U.S.?
A : In some ways, our approach to investing in emerging markets is very similar to investing in the U.S. Investors in the U.S. are typically buying stocks or bonds of companies. They may be analyzing financial statements, trying to understand the competitive environment in which a company operates, or looking at a sector and trying to determine where we might be in the business cycle for that sector. They are probably talking to the company’s management team to get a sense of how they are trying to move the company forward.
We are analyzing countries in the same way that U.S. investors are analyzing companies. We are trying to understand their financial situation, looking at how they compete with other countries in the global economy, and paying attention to where we the local economy is in its cycle. We are also very much concerned with where the government – the country’s management team, if you will – is trying to take the country.
The big difference is frequently logistics. Because we are investing locally in many countries around the world, the first thing we need to do is figure out how to open accounts in as many countries as possible. The account opening process can be quite time consuming. Frequently it takes three to six months to open an account in a country and in some cases it takes much longer. Then we need to understand all of the regulations surrounding moving money in and out of the country as well as around purchasing and selling securities. We need to understand trading conventions and settlement cycles. It’s a lot of detail when you consider that everything is different from one country to another. We’ve put a lot of resources into developing our ability to trade locally in emerging markets around the world. Quite frankly, we are really proud of what we have accomplished and I think we have one of the best operations in the business.
Q: Could you explain your investment process?
A : We have consistent application of a disciplined, repeatable investment process. Our long-term approach helps position our investment managers to capitalize on the inevitable overreactions of short-term investors, while also seeking to minimize losses to trading and, where appropriate, taxes. We're just trying to add value by taking lots of little bets.
We are adding value with a cluster of investments and not entirely dependent on the general risk movements of the markets.
We do a lot of traveling to visit countries. We speak to policy makers and experts in various areas of interest such as politics, economics and the general business environment. We want to understand both the local and regional dynamics.
Q: What are the analytical steps involved in your research process?
A : Our research is focused on in-depth fundamental analysis of economics and politics at the country level. Just as an equity manager might describe himself as a stock picker, we would describe ourselves as country pickers. So the focus of the research is in trying to identify countries that we think we experience either strong or weak growth.
When we start to get to investigate a country, we have a research associate go through all the available resources and prepare a detailed country report. These reports cover everything from the country’s demographics and history, to the structure of the economy, recent economic performance and politics. In doing this, we are developing a thorough background understanding of the country so that we are better able to interpret the importance of new developments within that country. Among the more important things we are seeking to understand here is monetary policy. If we are going to put money to work in a country, we want to see that the monetary authority is responsible and committed to providing a stable economic environment. If the monetary authority is subject to extensive political interference or is targeting something other than inflation, we are going to think twice before putting our capital to work there.
Once that is done, the next step would be to understand what is happening today. Is there something happening in the country that warrants investing? In particular, we are interested in what reforms the government is implementing or is planning to implement. The important question here is whether or not the government is working to improve the investment environment. A country in which the government is implementing investment-friendly reforms is one in which we are likely to invest.
Finally, we try to travel to the countries in which we invest. At the end of the day, the best way to learn about a country is to visit it. We will sometimes go on investor trips organized by the big investment banks, but we will also organize our own trips. When we go on these trips, we meet with a wide range of people: government officials (typically someone from the finance ministry and the central bank), opposition politicians, journalists, academics, local investors, representatives from the IMF or the World Bank, economics personnel from the U.S. embassy. The goal is to really dig around and test whether all you learned back in the office in Boston is valid. You can really avoid a lot of mistakes by going to a country and checking things out in person.
At this point, if we are still interested in the country it comes down to instrument selection and execution.
Q: Can you give us some examples of typical investments you have done that reflect your investment discipline?
A : We put a lot of effort into understanding what can go wrong with an investment and then try to structure the investment in a way that best protects us from adverse outcomes. A great example of that was our investment in Georgia. We had an investment there in 2008. We were aware of the conflict between Russian and Georgia over the breakaway regions in Georgia and were concerned that the conflict might escalate. At the time, there were a couple of easy ways to get exposure to the country: the government had issued some external U.S. dollar-denominated debt and so had the Bank of Georgia, the largest bank in the country. But rather than buying either of those bonds, bonds which we believed would perform badly in the event of conflict with Russia; we negotiated with the Bank of Georgia to place a currency-linked term deposit with them (a deposit denominated in the Georgian currency that earned the local interest rate). In the middle of the term, the Russians invaded. Sure enough, the external bonds of both the government and the Bank of Georgia sold off sharply. But the currency maintained its peg to the U.S. dollar our deposit matured a few months later with a profit. I would point out that Euromoney magazine recognized this trade as the deal of the year in Eastern Europe in 2008.
We are also at the forefront of investing in local markets. We have accounts open in over 80 countries around the world and this enables us to execute a kind of arbitrage trade that not many other investors can do. In normal circumstances, a foreign exchange forward will implicitly provide an investor with the same return as a local market T-bill. Sometimes, however, the relationship between the t-bill’s return and the forward’s return breaks down. Typically this happens when there are some restrictions in place on foreigners’ ability to participate in local markets and market participants have become bullish on the country. That is currently the case in Sri Lanka.
With the end of the 30-years’ civil war in the country, things are really picking up there. A lot of investors want to invest, but the procedure for opening an account takes time and is somewhat cumbersome. Furthermore, the government places restrictions on how much of the outstanding government debt may be held by foreigners. For most investors who want to have exposure to the country, the only option is to buy the Sri Lankan rupee in the forward market. Because of this, the yield implied in the forward price of the currency has fallen below the yield on the local market t-bills. We, however, opened an account in Sri Lanka two years ago so we were prepared when the civil war ended and we bought the t-bills. Now, what we are doing is holding the t-bills and we have sold the currency in the forward market. The result is that we have no net exposure to the currency, but we are earning the interest rate spread between what is implied in the currency forward market and what we get on the local market t-bills. It is a great, low volatility source of returns.
Q: How do you get a better understanding of the macro environment?
A : We utilize many sources of information in understanding the macro environment in emerging market countries. These sources include local newspapers, dedicated emerging markets news sources, as well as consultants and local economists who are based in the countries in which we are investing. We attend conferences at which policy makers from emerging market countries speak. We also travel extensively and the importance of that travel cannot be underestimated. We try to visit all of the countries in which we are invested and meet with government officials – especially people from the finance ministry and the central bank where economic policy is formulated – journalists, academics, opposition politicians, local investors, and officials at the U.S embassy. In doing this, we are able to get a firm and well-rounded understanding of the economy and political dynamics in a country.
Q: What are the risks of investing in emerging markets and how do you contain them? How do you handle regional risk having in mind that emerging markets are highly co-related?
A : First, you have to keep in mind that most emerging market countries are economically dependent on trade with developed markets. There are some exceptions, but for the most part that is what you are dealing with. So it isn’t just what is happening in a particular country that may drive investment returns, it may also be that what happens in the US or the EU is equally important.
Second, politics is critical. You’ve got to be aware that the political situation in a country can change on a dime. Whether it be an election that installs someone like Hugo Chavez in power or a coup d’etat, you need to be prepared for political change. At the same time, you also have to be willing to look past the political noise. Sometimes, the politics is priced into the market or it just doesn’t matter for one reason or another. You need to be open to that possibility as well.
With respect to regional risk, I think our approach handles that well. We are not making large deviations from our benchmark so we are basically always going to be exposed to all regions. Within that framework, we then seek to add value by being overweight the stronger countries in a region and underweight the weaker countries. If we are right in our country selection, we will outperform regardless of what happens to the region.
Q: Why should investors consider investing in emerging market bonds?
A : There are several reasons why a strategic allocation to emerging market local bonds makes sense. First, it is the long-term economic growth. Many emerging market countries have really learned form their mistakes in the past and are on the cusp of making great strides in their development. Countries like China, India and Brazil are on everyone’s radar screens. But there are others as well: Indonesia is likely to do well over the next several decades, Sri Lanka is coming out from under the burden of a 30-years’ civil war, Colombia is still fighting its civil war but has made great strides in improving the security situation in the last seven years. There are all of these great stories out there about countries that are poised to do well over the long-term. As an investor, you should be looking to get exposure to these stories.
Second, many developed countries face demographic problems – that is to say population growth has stagnated or gone into reverse. A stagnant or declining population will tend to lead to a lower economic growth rate. Populations in emerging market countries in general continue to grow and we can expect them to experience stronger economic growth as a result. We expect this to lead to a decline in the currencies of developed market countries relative to the currencies of emerging market countries over the long term. Owning local currency bonds in emerging markets is a great way to play this long-term trend.
Finally, interest rates in most emerging market countries are higher than interest rates in the developed markets. So a fixed-income investor who is concerned about earning an income stream would do well to have exposure to the emerging markets where he can earn a higher rate of interest.
I’d also point out that in the global financial crisis of the last two years, emerging market countries have fared very well. In Latin America and Asia, there hasn’t been a single bank failure related to the crisis. Countries in those regions learned from their experiences in the 1980’s and 1990’s and implemented real reforms that protected them in this latest crisis. To paraphrase an old automobile ad in the U.S.: These aren’t your father’s emerging markets.