Locally denominated debt securities in emerging markets expose investors to a variety of risks driven by foreign exchange, credit quality, interest rates, macroeconomic conditions, and regional politics.

This unique combination of risks, in our view, warrants special emphasis on limiting the downside potential—one that requires manager skill—while wringing value from market exposure to the potential for attractive yields and income.

Limiting the Downside—and the Role of the Tracking Error

Toward establishing a discipline of measuring and attaining limited downside potential, we propose looking at one of the most common gauges of volatility—the tracking error—and putting it in perspective.

A portfolio’s tracking error is not an adequate measure of volatility, because it gives equal treatment to the positive and negative differences between a portfolio and its benchmark—even though the former are obviously desirable, whereas the latter are not. For example, a theoretical portfolio that managed to stay roughly flat during a severe downturn would be characterized by a large tracking error on the upside, much to investors’ benefit.

A Strategy for Limiting Downside Potential and Seeking to Achieve Returns

To reduce volatility throughout the emerging market cycle, we propose the following loss-mitigation strategy:

• Maintaining a low tracking error and high volatility in risk-on periods.

• Maintaining a high tracking error and low volatility in risk-off periods.

We also propose a multi-part framework for riding out emerging market gyrations and achieving above-market annualized returns—one that includes global macro analysis, establishing a risk budget, determining country-level risk and security selection.