Investing for tomorrow: applying ESG principles to emerging market debt
There is no longer just a single EM group, with poor countries converging to industrialized status slowly and surely over time, and advanced emerging markets graduating to developed countries. With a deeply skilled ESG research team, we have amassed the data and monitoring capabilities to tailor and craft a unique approach suited to the nuances and dynamic realities of emerging markets. The novelty of our approach is that instead of inclusion lists or exclusion lists, we use our composite score on each of the 90 EM countries to determine position sizing for investments in our portfolios. We must look to the future and take a stand on the implications of our enterprise and the long-term viability of our holdings.
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In our view, there are compelling reasons for understanding and appreciating the investment opportunities in the Nordic countries, which top international rankings for economic performance, innovation and social well-being.
OVERVIEW Institutional investor portfolios typically hold a signifi cant allocation of foreign currency denominated assets. Left unmanaged, this currency exposure functions like a buy-and-hold strategy which receives little or no risk premium and adds unwanted volatility to portfolio returns. In this paper, we discuss the variety of solutions to address foreign currency exposures such as using passive currency management choices or selecting from the different active currency management solutions available.
How have different investment styles impacted corporate behaviour and equity performance? What influence do asset managers and investors really have? These are just some of the questions we posed to our experienced equities panel, covering views from our active, passive, systematic and SRI/ESG teams.
Over the last few years, the focus on indexation within asset management has driven interest in new forms of indexation, also known as smart beta. Raul Leote de Carvalho, Co-head of Financial Engineering at BNP Paribas Investment Partners, explains that smart beta strategies are driven by long-established factor exposures such as value, low volatility, small capitalization, and momentum. Thus, he believes that investor attention will shift away from the more empirically defined smart beta indices available today, and move towards more efficiently crafted and founded factor centric strategies.
OVERVIEW During the latter years of the last decade, adverse market conditions demolished the funding status of many defined benefit (DB) pension plans and demonstrated the need for improved approaches to risk management. In their recent paper, “Decomposing Funding Ratio Risk: Providing pension funds with key insights into their liabilities hedge mismatch and other factor exposures”, senior members of the financial engineering and multi-asset solutions teams at BNP Paribas Investment Partners provide a new and novel framework for obtaining key insights into the principle investment risks faced by DB pension funds. We asked the authors to provide us a summary of the main findings from the paper, which they have provided below.
Investors’ appetite for funds providing capital protection has been increasing in recent years. This is particularly the case for individuals saving for future life events such as retirement, buying a home or helping fund their children’s education. It can be explained in large part by the growth in defined contribution pension schemes and the rollercoaster performance of the equity markets over the past two decades. Upside potential remains important to investors in capital protected funds, but not at any cost, and they demand that a certain minimum level of their capital be protected. With this in mind, we have investigated the best way to design and manage portfolios providing capital protection. This document is a short summary of a research paper entitled ‘Portfolio Insurance With Adaptive Protection’, which provides a comprehensive mathematical explanation of our findings.
The ‘low-risk anomaly’ has been around for over 40 years. Empirical evidence shows that low-volatility investment portfolios can produce higher returns than riskier portfolios (in particular when adjusted for risk) while providing some level of downside mitigation. This anomaly represents a departure from traditional financial theory – where taking on risk is generally expected to yield greater returns.
Currency investing started in earnest with the introduction of floating exchange rates after the breakdown of the Bretton Woods system in 1973.
Volatility targeting is a strategy that rebalances between a risky asset and cash in order to target a constant level of risk over time.
We give strong empirical evidence of a risk anomaly in equity sectors in a number of regions and countries of developed and emerging markets, with the lowest risk stocks in each activity sector generating higher returns than would be expected given their levels of risk, and the converse outcome for the riskier stocks. We believe this evidence is a likely consequence of the fact that equity analyst and active fund managers tend to specialize in particular sectors and to mainly select stocks from those sectors. Additionally, constraints restricting the deviation of sector weights in active portfolios against their market capitalization benchmarks are often used by active fund managers, in particular by quantitative managers which tend to go as far as being sector neutral. As a consequence, we find that sector-neutral, low-risk approaches appear more efficient at generating alpha than non-sector neutral approaches, with the latter showing strong sector allocation towards financials, utilities and consumer staples than sector neutral, at least when applied to developed countries in a global universe. We also discuss some properties of low-risk investing such as tail risk, turnover and liquidity.
Intertemporal risk parity is a strategy that rebalances risky assets and cash in order to target a constant level of ex ante risk over time. When applied to equities and compared with a buy-and-hold portfolio it is known to improve the Sharpe ratio and reduce drawdowns. We apply intertemporal risk parity strategies to factor investing, namely value and momentum investing in equities, government bonds and foreign exchange. Value and momentum factors generate a premium which is traditionally captured by dollar-neutral long–short portfolios rebalanced every month to take into account changes in stock, bond or foreign exchange factor exposures and keep leverage constant. An intertemporal risk parity strategy rebalances the portfolio to the level of leverage required to target a constant ex ante risk over time. Value and momentum risk-adjusted premiums increase, sometimes significantly, when an intertemporal risk parity strategy is applied. Volatility clustering and fat tails are behind this improvement of risk-adjusted premiums. Drawdowns are, however, not smoothed when applying the strategy to factor investing. The benefits of the intertemporal risk parity strategy are more important for factor premiums with strong negative relationship between volatility and returns, strong volatility clustering and fat tails.