Where are the alpha opportunities in EM debt?

In very simple terms, emerging markets are half the world's population, half the world's GDP and more than half the incremental growth. It is also an inefficiently priced opportunity set, so less information, more noise, less facts, more opportunities for active managers who know what they're doing to uncover interesting ideas and avoid future disaster. So emerging-market debt should be considered.

The weights and the countries tend to be quite different. In very broad terms, emerging-markets equities tend to have more of an Asian bias. Emerging debt tends to have more of a Latin American and commodity bias.

Even at the company level, we don't see much overlap. Equities that are being issued tend to be more growth-oriented companies — technology or consumer-led — and those industries tend not to carry a lot of debt, nor should they.

Then you have large industrial companies, commodity producers and state-owned enterprises. Those tend to be more your debt issuers. So, in fact, there's not a lot of overlap of issuer or country.

Global synchronous growth. That's always good. It's good for developed countries, and it's certainly good for emerging countries.

They tend to be exporters into the developed world. They always need capital in one form or another, debt or equity, and so in this environment of low global yields but improving growth, and a bit more readiness from developed markets to take on risk, money tends to flow to emerging countries.

Defaults ultimately happen because of liquidity, not necessarily just solvency, and in an environment of very low and declining interest rates, the access to capital has been easier. So you're not going to default because there are a lot people around the world who will lend you more money to refinance your debts. You can actually lower your interest costs in some cases.

On the commodity side, the commodity collapse was very severe but it was dampened by both very low interest rates and the fact that oil prices recovered relatively quickly. If those low prices had persisted for a longer period of time, you would have seen many more defaults.

There are a couple of issues with passive. If it's truly passive and tracks a benchmark, that's a worry — a debt index is kind of a record of failure. The more you borrow, the bigger you are in the benchmark. The passive strategy's going to allocate more to an increasing borrower, so that's probably not very bright.

The other thing is that passive, such as via an ETF, inherently requires liquidity. Emerging has lots of excitement to it and lots of good features. Liquidity isn't one of them.

I don't think the ETF business has really been tested in an emerging context. The last time we had a big sell-off in emerging markets, ETFs were nonexistent or a very small share of the market.

We're an active manager, so none of those opinions should surprise you. But the combination of illiquidity and having a blind allocation to a benchmark that's based on leverage is probably not wise.

I would speculate it can't be just pure retail. I think there are advisers using it and maybe even institutional accounts trying to make a quick allocation, almost like a top-down macro or beta call, rather than building a portfolio from the bottom up.

Fundamentals ultimately matter. In the short term, a top-down beta call makes you money, but in the long term, monitoring the fundamentals, having the proprietary research process and staying close to the country's or issuer's fundamentals are more durable.

Eventually the market recognizes that a country's debt is declining. Its [foreign exchange] reserves are improving. Governance is getting better. The market will re-rate that country sometimes before, sometimes after the rating agencies upgrade it.

And monitoring the fundamentals is important for the downside, too. You get out of a deteriorating situation before the rating agencies do, before the sell-off occurs, and that's the value of active management. And that goes hand in hand with bottom-up research.

No one wants to lend new money to the government of Venezuela. We're buying secondary market securities that have been issued over the years. There's not an ethical issue of owning a secondary market security. If anything, we're a thorn in the government's side.

We expect one day to have a better regime in power in Venezuela and to be able to negotiate some sort of debt restructuring and debt reprofiling with a new administration.

It broadly will continue. It needs to be justified by fundamentals getting better, which they are, in terms of stabilization of commodity prices and growth.

Even in places like Brazil, where you're seeing a recovery of growth, the fundamentals need to justify the incremental flows. But we still see a better yield opportunity there than in the U.S., Japan or Europe.

Institutional investors still need income, and if anything, the rally in equities has probably started to trigger some, [with investors saying] 'Let's rebalance our risk profile out of equities into fixed income.'

I manage a hard currency strategy. Ninety, 95% of the bonds at any point in time in my portfolio are actually dollar-denominated.

I tactically invest in local markets in the local currency government bonds when it makes sense. When is that? That is typically when the country has had an increase in their inflation rate where the central bank has had to raise rates, and now inflation is under control and the central bank can start cutting rates. Or if you have a growth downturn like we had in the U.S., the central banks will become very dovish and start cutting interest rates. You can get some capital appreciation from owning local bonds as rates are cut.

Sometimes you have to take everything as a package. If hedging the local bond is expensive, you need to take the currency and the local rates. Other times it's relatively cheap to hedge the currency. We generally separate the decisions and analyze them separately, and either hedge or sometimes hedge with a proxy.

I'll use the example again of Brazil. We don't think the currency's overvalued. Commodities have stabilized and we like their bonds. Their currency's okay, but to de-amplify the risk to a dollar-based investor owning that currency, we hedge by selling, let's say, the Australian dollar or the Chilean peso, something that's correlated but isn't as expensive to hedge as Brazil itself would be. To be clear, if investors are buying dollar-denominated bonds like those that I manage, they're not taking direct FX risk. There are nuances though.

If a country has its currency depreciate massively for whatever reason, there are credit implications. So you're not immune to FX weakness when buying dollar-denominated bonds, but you don't take the entire hit like a local bond would.