Stockholm (HedgeNordic) – Elo Mutual Pension Insurance Company, the third largest among Finland’s four pension insurance companies, manages an investment portfolio exceeding €30 billion. Fixed-income investments constitute approximately 29 percent of this portfolio, with emerging market debt also playing a strategic role. Despite representing a smaller portion of the €8.6 billion fixed-income portfolio, Elo’s fixed-income team has a well-defined approach to gaining exposure to this asset class.

“It’s the same old discussion about risk and return,” Eero Ketola, Elo’s Head of Fixed Income, sheds light on the role of emerging market debt within their portfolio. “It plays the role of providing good returns over time, but also serves a fairly good diversifier,” he elaborates. “In Elo’s case, the diversification benefit is emphasized by the fact that we only invest in emerging market sovereign debt, avoiding exposure to emerging market corporate bonds.” Considering that higher-yielding fixed-income instruments are often associated with corporate issuers, the allocation to emerging market sovereign debt “provides a small boost to diversification,” explains Ketola.

“Emerging market debt not only acts as a diversifier but also as a decent return contributor as well.”

With the emerging market debt universe encompassing both hard currency and local currency debt, the diversity and diversification benefits of this asset class become more evident. “If we go deeper into emerging market debt, we invest in both hard currency and local currency, and within the local currency segment, we consider both the vanilla local currency and also frontier markets,” says Ketola. “These smaller buckets contribute to portfolio diversification.” Amid high interest rates globally, “emerging market debt not only acts as a diversifier but also as a decent return contributor as well.”

Local Versus Hard Currency Debt

Discussing the team’s preference for local currency or hard currency emerging market debt, Eero Ketola highlights that the long-term strategic allocation tends to be evenly split. “On a structural basis, it’s a fairly even split between the two. However, on a tactical level, we do make adjustments as needed,” explains Ketola. “This tactical adjustment depends on our view of the global economic environment, market conditions, pricing dynamics, and other factors relevant to portfolio management.”

While acknowledging that forecasts “usually don’t age well due to markets moving quite rapidly,” Ketola suggests that the current environment favors local currency debt. “Hard currency follows the same path as traditional corporate credit, whether it’s investment grade or high yield,” begins Ketola. “Given that spreads are not particularly wide at the moment, hard currency doesn’t offer huge value at the moment,” he emphasizes. Considering that returns on local currency debt are influenced by local yields, shifts in yield curves, changes in inflation expectations, creditworthiness, and currency movements, the current opportunity landscape appears more compelling for this segment.

“The heterogeneity of this market is the number one characteristic that shapes our approach to investing in emerging market debt.”

One pitfall of analyzing emerging market debt is the attempt to box in over a hundred heterogeneous countries within one asset class. “The number one risk or pitfall lies in treating this exposure as one bet,” warns Ketola. “The heterogeneity of this market is the number one characteristic that shapes our approach to investing in emerging market debt,” he elaborates. Elo adopts an active strategy by considering country-by-country differences. “There are huge differences between countries in terms of the value they offer, as well as the risks and opportunities they present,” says Ketola. “Index investing is not the right play in this asset class.”

Managing Investments In-House and Use of External Managers

Hard currency emerging market debt functions as a credit product offering a yield premium over U.S. Treasuries in the case of U.S. dollar-denominated debt. The fixed-income team at Elo headed by Eero Ketola has chosen to handle all investments related to hard currency debt internally. “We don’t have any outside managers to help us get exposure to hard currency, and we take a bit of pride in our ability to do it internally,” says Ketola. “While our resources and manpower in this area are not extensive, they are sufficient. Our internal management approach has shown promise so far.”

“We don’t have any outside managers to help us get exposure to hard currency, and we take a bit of pride in our ability to do it internally.”

Given that local currency debt returns are driven by local factors and require specialized local expertise, Elo has chosen to rely mainly on external managers to access this segment. “On the local currency side, we recognize that our internal resources are insufficient to cover the entirety of the market, including a large number of countries with unique yield curves and market dynamics,” acknowledges Ketola.

Manager Selection

Elo’s primary criterion for selecting managers revolves around their alignment with the pension fund’s investment principles and their commitment to an active management approach. “We do not invest in index trackers or enhanced index trackers. Instead, we prioritize active management and seek managers who can demonstrate their ability to generate alpha. This is what we are seeking and paying for,” explains Ketola.

“On the local currency side, we recognize that our internal resources are insufficient to cover the entirety of the market, including a large number of countries with unique yield curves and market dynamics.”

Elo relies on both local and global managers to access local currency emerging market debt, with no preference for either. “Finland is a small country, and the finance industry is even smaller, but we are happy to have managers here investing in emerging market debt,” points out Ketola. “However, we don’t have any specific bias or home market preference,” he emphasizes. “We try to find and select the best managers available, prioritizing efficient diversification over excessive diversification.”

“We begin by closely monitoring a short list of managers,” Ketola elaborates on the manager selection process. “We then conduct thorough due diligence, which includes both quantitative and qualitative assessments. This involves engaging with potential managers, with us visiting their offices, and managers visiting our own offices,” he continues. Once Elo’s team has established a level of comfort with a manager, the allocation is increased in a step-by-step manner. “This gradual approach helps us avoid any timing issues,” notes Ketola.

Elo adopts an active approach when investing in hard currency debt, and expects the same approach from external managers handling local currency debt. “We conduct thorough region and country analyses when making investments ourselves, and we expect the same of our external managers,” stresses Ketola. Elo has incorporated its responsible investment philosophy, including environmental, social, and governance (ESG) considerations, into its investment process. As a result, Elo’s team closely monitors how managers incorporate ESG factors into their investment decisions.

“We conduct thorough region and country analyses when making investments ourselves, and we expect the same of our external managers.”

“We have the traditional financial macroeconomic analysis as our foundation, and combined with that, we integrate responsible investment principles on the E, S, and G side,” explains Ketola. In addition to monitoring green initiatives aimed at addressing pollution and mitigating global warming, on the social side, Ketola and his team assess “the stability of the economy, adherence to human rights, and other related factors, including equality and educational issues.” According to Ketola, governance is also a major consideration, highlighting the importance of governmental and institutional stability in enhancing living standards. Whether investing directly or through external managers, Elo’s goal is to identify “stories and investments that are on a sustainable path to prosperity,” Ketola concludes.