This is a challenging period for investors in emerging market debt. Even before investors started unwinding positions in anticipation of higher rates in the developed world, the kinds of opportunities enjoyed by those who came early to the asset class had grown scarcer, and traditional top-down and bottom-up approaches were becoming less effective.

Rather than simply adopt overweight or underweight positions on certain countries or instruments, investors may want to consider a thematic approach to EM debt. Thematic investors seek to identify trends in asset prices driven by changes in fundamentals, politics or regulations, or a combination of all three. These trends may be idiosyncratic and specific to a particular country or company, or they may originate in the developed world and span a number of markets and assets.

Thematic investing depends on good timing…and requires very strong risk management.”

Thematic investors aren’t immune to dislocations in turbulent markets. High correlations, in particular, can be a challenge. Yet by spotting and acting on trends, they may also be able to turn the turbulence to their advantage. For example:

  • Investors anticipating monetary policy divergence among G-10 countries might switch short dollar positions to short positions on the currencies they expect to weaken. A thematic investor would buy the currencies of the countries expected to increase rates and sell the currencies of those countries expected to decrease rates or maintain low ones
  • Currency wars that developed between the US and certain EM countries during the Fed’s first two rounds of QE. Some countries responded by competitively devaluing their own currencies; others chose instead to allow their currencies to fluctuate.
  • The Mexican real estate market--a more idiosyncratic, country-specific theme. A new administration redirecting subsidies away from single-family homes in commuter towns—a disaster for some homebuilders. A thematic approach would have been to research the likely thinking of the incoming policymakers and avoid Mexican homebuilder bonds.

Thematic investing depends on good timing. The objective is to identify a theme before it becomes obvious to everybody else, and to position your portfolio accordingly. It is also vital to scale out at the right time. Achieving this requires very strong risk management: thematic investing is more difficult to manage and size than more traditional approaches. Each theme has a life of its own and requires an understanding of its evolution, performance attribution and correlation with other themes.

It takes resources and prudence to pursue a thematic approach to EM debt but it can be an effective way of capturing alpha in markets that are sometimes volatile, sometimes quieter, but increasingly rich in both complexity and opportunity.