Emerging market debt-focused hedge funds are staying patient amid “weaker alpha environment” – here’s why…

The rally in emerging markets has “eroded the potential for alpha generation” in EM debt markets, but this weaker investment environment is only temporary, with hedge fund managers keeping their powder dry to capitalise on opportunities at a later stage.

The rally in emerging markets has “eroded the potential for alpha generation” in EM debt markets, but this weaker investment environment is only temporary, with hedge fund managers keeping their powder dry to capitalise on opportunities at a later stage.

Lyxor Asset Management strategists said in a recent market note that more fragmented recoveries and uneven growth drivers across EM countries, coupled with increased political volatility in developed markets, could offer fresh alpha ideas further down the line following a summer recovery lull.

Earlier, March’s market turbulence saw emerging market hard currency debt spreads gap out to almost 700 basis points as the coronavirus crisis struck EM economies.

But a variety of hedge fund strategies that trade EM debt – including global macro, fixed income and relative value strategies – successfully navigated the historic rupture, said Lyxor senior strategists Jean-Baptiste Berthon and Philippe Ferreira, and hedge fund analyst Nicolas Quirin.

“They benefitted from their reduced overall exposures and their tilt on higher quality issues,” they wrote in the commentary.

Lately, though, a continued economic recovery, along with lockdown easing and Covid-19 trends generally heading lower – India excepted – has driven EM debt spreads tighter, where they are now just 30 bps off pre-crisis levels.

At the same time, the reopening of China’s economy has spread to consumption – a key driver for broader EM economies – while heightened political risks in developed markets, such as the US presidential election and Brexit, coupled with improved dollar liquidity and global trade recovery, has lured investors towards emerging market hard currency debt.

All of which has put a lid on alpha opportunities for now, according to Berthon, Ferreira and Quirin.

Though such hedge fund strategies were able to “keep the lion’s share of their alpha” since March’s crash, weaker summer liquidity, less attractive valuations and record EM debt issuance has prompted managers to start building up cash positions.

“The dispersion across EM debt assets, which climaxed in April, has vanished across countries, ratings, sectors, and maturities,” they continued, pointing to fewer regional relative-value opportunities and a less-diversified set of drivers since June.

But, against this backdrop, hedge fund managers are “keeping dry powder” to capture opportunities at a later stage. 

“We believe this weaker alpha environment is only temporary,” the strategists noted.

Splintering inflation trends and central bank targets, and uneven growth drivers amid deglobalisation, offer a more fragmented landscape going forward, which could be further exacerbated by differing impacts on EM trade from the US election and US-Chinese relations.

Underpinning this, a softer commodity cycle, concentrated supply chains, developed market ageing, and protectionism could further hinder global trade from reverting to the previous cycle levels.

“Current EM debt spreads might not reflect the uneven EM countries recovery prospects. The pandemic left deep scars in most of them, which are calling for more stimulus support,” added Lyxor’s strategists.

“We therefore expect a more discriminating environment for EM assets to return, favourable for alpha generation. In the meantime, we still think EM debt provides valuable diversification in a credit portfolio, with an annualised 4-5 per cent yields.”