“Investors are now coming to grips with the evidence that the traditional way of investing in emerging market debt, that is through the benchmark, may not working properly even though that is how 85 per cent of investors did it,” he says.

“Now we’re seeing investors increasingly move away from that method and, if you look at the flows, over the past two years there have been massive outflows from benchmark funds.”

More active and diverse funds are picking up that slack, successfully finding alpha in the steadily maturing asset class of emerging market debt.

“If you look at the component of blended managers such as ourselves, who are able to be active in allocating to different asset classes, this category has progressed over the past two years,” says Buchet.

“There is a shift away from the traditional approach which is beta-focused only, and I think this is for the better. Investors are getting over this conservatism around emerging market debt to unlock value.”

The advantage of EM debt, he says, is that it has reached a critical juncture in terms of its growth story.

“The diversity of situations offered in an EM debt portfolio is significant which means that EM debt will give institutional investors both more reasonable returns and improved diversification in terms of risks,” he says.

While many funds may already be familiar with emerging market equities, Buchet says, the highly differentiated universe of emerging market debt – based as it is on the dynamism of growing economies, improved credit ratings, and the rise of local currency debt markets – may offer some of the best opportunities within the EM space.

“If I compare EM equities with EM debt, the EM equity index is 75 per cent invested in four countries – China 25 per cent, Taiwan and Korea 16-17 per cent each and India around 20-22%. That doesn’t make for a very balanced investment universe,” he says.

“In EM debt, we are way more diversified than that. If I were to take a one-third index of the entire EM debt spectrum, no new country would be higher than 7-8 per cent.”

For commodity bulls, in particular, EM debt is emerging as an attractive investment.

“There is way more commodity exposure in EM debt than in EM equities, both directly and indirectly,” Buchet says. “Many government debts are highly dependent on oil, gold, and mining metals, whereas the direct mining and metals exposure in the equity space is no more than 10-15 per cent.

“Roughly half of the EM debt universe comprises quality players to different degrees.”

According to Dan Farmer, chief investment officer at MLC Asset Management, emerging market debt is bringing strong diversification benefits to the portfolios it manages.

“Over the past two years, global central banks have been normalising higher yields in order to contain inflation and bring price stability into their economies,” says Farmer.

“We are becoming more cautious about the economic cycle as higher rates have a negative impact on economic growth.”

To mitigate this risk, Farmer says, MLC has been allocating to more defensive asset classes such as fixed income, increasing the underweight to more neutral positions in its diversified portfolios.

“Our view is that if the global economy and unemployment increases drastically, the probability of recession will increase and bond returns - as yields fall and prices increase - will help offset the potential negative returns in the growthier allocations in our portfolios like equities,” says Farmer.

And the future of EM debt?

Buchet says that tectonic shifts within the asset class (for instance, the disappearance of Chinese property credit and the exit of Russia from all indices matched by the arrival of Chinese and Indian local debt and the rise and rise of Middle Eastern sovereign debt) could mean that its themes are in a “constant state of recomposition”.

“As it moves away from a beta to an alpha play, my best advice would be to allow any EM debt manager you onboard enough space to express convictions away from the straitjacket of an index.”

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