Beyond the benchmark: redesigning emerging market debt allocations

Franklin Templeton analysis shows popular emerging market debt (EMD) indexes are limited by their focus on the largest and most developed countries in the world, resulting in unattractive spreads and limited risk diversification.

Many EMD indexes used as the basis for passive or active strategies are weighted by total debt outstanding. Even though they allocate to 70 countries, by design, they tend to be dominated by the largest issuers, thereby introducing concentration risk.

Meanwhile, there is a growing and deepening market of emerging markets bonds denominated in hard currencies other than the dollar.

The market beta of frontier markets – the expected move in an investment relative to movements in the overall market – is further reduced by the idiosyncratic nature of the return profiles, making them less correlated with emerging markets and the broader global markets.

Franklin Templeton proposes that a more effective EMD investment approach looks beyond traditional benchmarks to include select frontier markets, local currency bonds and emerging markets corporate debt.

In this way, reserve managers can achieve greater diversification, enhanced yield and reduced downside risk when investing in EMD.