Investing beyond the mainstream

Mr Paldynski, you are in charge, of the UI - Aktia EM Frontier Bond+. What is your investment philosophy for this fund and for Aktia Asset Management in general?

Henrik Paldynski: We have a very broad investment universe overall, currently covering more than 140 countries and comprising both emerging and frontier markets. We analyse each country and market using our own quantitative research models. Not only do we take the current performance and fundamental data of the respective markets into account but also keep a particular eye on trends. Even if several indicators show low levels, we can sometimes identify a positive trend. And this is exactly where we want to invest: in countries that are improving, developing and showing a positive trend. However, ESG criteria, which are an important part of our analysis and strategies, also need to be showing signs of improvement, not just the fundamental data. This is central to our investment philosophy. We perform both quantitative and qualitative analyses. The approach to our strategy is therefore both systematic and discretionary, with the aim of achieving the maximum added value for our investors.

Why is it so important to have a qualitative approach alongside the quantitative analysis?

In some cases, fundamental data changes very gradually and sluggishly. What’s more, concrete measures such as reforms are not immediately reflected in the data. Emerging markets reforms always take a certain amount of time to have an impact and to then be reflected in the data. Turning points in emerging markets or frontier markets are often politically driven and cannot be immediately identified in the data in question. Therefore qualitative analysis is important.

And this type of analysis is presumably all the more crucial in niche markets such as Kenya or Uganda?

Exactly. The countries in which we invest can be safely described as small caps in the bond sector, while e.g. Mexico and Brazil could be classified as large caps. But just as with small caps on the equity side, we have established that there is quite little research on frontier markets. This means we can achieve real value with our analysis and expertise, which can be attractive for any portfolio in the current interest rate environment. Attractive returns can thus still be generated with bonds in emerging markets and frontier markets. For example, currently our portfolio yields 14,6% on average with a relatively short duration of just over two years (end of April data). Moreover, bonds from frontier markets have a far lower correlation to other asset classes because there is less international investment and because the drivers are often local.

Let's dive deeper into your strategy for the UI - Aktia EM Frontier Bond+. You have integrated a traffic light system into your investment process. What is your reasoning?
All investable countries are anchored in the traffic light system. Our universe of investments is divided into three types of countries: those in which we do not invest per se, those we are ready to invest in but not willing to fund the authorities, and those we have no hesitations about investing in. Only after classifying potential investments as suitable from a fundamental perspective, where economic and ESG issues are covered, we go into the deep dive of valuations. However, the colour of the traffic light can, of course, change for example if there is a new political situation. In this case, we adjust our positions in these countries accordingly. Our red list includes Turkey, for example. We have not been willing to fund the Turkish and Russian governments for years. All investments into Russia have been blacklisted in 2022.

And how do you construct the portfolio exactly?

The portfolio is made up of country and currency investments. Complex investment instruments are avoided. Our portfolio therefore comprises government bonds, T-bills, inflation-linked bonds, bonds issued by AAA-rated development finance institutions and FX derivatives. Development finance institutions play an important role in our portfolio as they invest in e.g. microfinance, SME-lending and infrastructure projects in the countries in question. Through targeted investments in development finance institution bonds, we can invest in a country with a clear conscience and support it without providing funds for government that might require critical scrutiny. It is important that we continue to focus on the countries and the respective macro risks first. Selection of the instruments and valuations is the next step.

You also invest in FX derivatives. What kind of added value do you generate for the portfolio in this case?

The FX derivative is the most liquid of the portfolio’s positions. In addition, the currency derivatives enable us to profit from economic development in countries in which we do not want to fund the government in office at the time. In this respect, the market in local currencies is a completely different one to that in hard currencies. Hard currencies show a greater correlation with key market movements and are also more sensitive to general market sentiment. Local currencies, on the other hand, are driven more by local investors, local inflation and local growth prospects. Local currencies are therefore an attractive diversification for the portfolio. This is also true for the overall portfolio construction. In addition, the returns from local currencies - especially in the frontier markets – are certainly more attractive.

The UI - Aktia EM Frontier Bond+, for example, invests into Egyptian, Kenyan and Ugandan currencies. How do you manage the risk and volatility of these currencies?
It is important that we diversify on the currency side. We currently have about 30 different currencies in our portfolio. The less liquid a currency is, the smaller the position in our portfolio. The stability of the respective central bank or the currencies’ historical volatility are also important factors. Ultimately, however, we do not place bets on individual currencies or their expected trends. The point is rather to be compensated for the existing risk or volatility with a corresponding yield. It is important for our risk management that we not only analyse the economic and fundamental data but that we also look at the country’s political, social and environmental risks and include these in our analysis. In this context, ESG factors are very important for us.

What are your fund’s current positions and where do you see the greatest investment opportunities?

In 2021 we strongly increased our exposure in Uganda and Uzbekistan. When we increased our position in Uganda in April 2021, there were very few foreign investors with positions in the country. Interest rates were also very appealing and we forecast strong economic growth in Uganda for the coming years. Furthermore, Uganda’s inflation rate is currently stable and attractive - especially in the light of rising inflation in Europe and the US. What’s more, political risks in Uganda are significantly lower since the election in 2020.

And why is Uzbekistan so appealing?

We are in very good contact with the local authorities in Uzbekistan and are very optimistic about the country's progress. Our investment in Uzbekistan is particularly interesting if you consider the country’s history of reform. Until 2016, the country and economy were pretty much closed to foreign investors. The situation has since changed and Uzbekistan is increasingly opening up. A string of social and economic reforms are in the making or being implemented, at times in collaboration with international financial institutions. The Uzbek authorities want to learn from other countries’ experience in the reform process, and this is having a very positive effect.

Let's talk about your investment team: in spring 2021, there was a reshuffle of parts of Aktia’s Emerging Markets Debt team. You are the new head of the EMD team. Have these changes influenced the investment strategy or the investment process?
We have had a lot of talks with new and existing investors about the investment team reshuffle, of course. The key point is that the investment process and investment philosophy have not changed. In addition, a lot of portfolio managers in the current emerging markets debt team have been with Aktia for years. I, for example, have worked at Aktia Asset Management since April 2009. And the performance in the first nine months following the team changes speaks for itself: we achieved the highest outperformance and the best Sharpe ratio since the strategy was implemented. Sometimes it is right to introduce fresh ideas and thought processes. We are also naturally continuing to develop our strategy and to make targeted improvements in order to remain as successful in the future as we are now.

In particular a lot of equity funds are currently focusing on ESG criteria. You have already mentioned that this is also important for your approach. How do you implement ESG factors in your strategy?

It certainly makes a difference whether you are implementing ESG criteria for emerging and frontier market governments or for US or European equities. But as a long-term investor, it is clear to us that environmental, social and governance factors should be part of one's analysis. This forms the core of the fundamental analysis in our strategy. The lack of ESG data is, however, currently problematic in frontier markets. Therefore we focus on our own quantitative analysis in our investment process. We are, however, observing an improvement in the data situation, while emerging and frontier markets are also becoming steadily more transparent in their ESG reporting as they increasingly realise that this has become a basic investment requirement for many foreign investors. Egypt and Uzbekistan, for example, have already issued green or sustainable development goal bonds.