T3 Unveils EM FX Index

Investors looking for exposure to emerging markets FX have
limited options, with most EM indices offering exposure (currency hedged or
otherwise) to local equity and bond markets. They will soon have the
opportunity to invest directly in EM FX markets, however as T3Index is set to
launch its E8 index, which it
says it a first of its kind as it measures the performance of the world’s eight
largest emerging market exchange rates.

T3Index is
a research driven financial indexing firm that specialises in derivatives
benchmarking and the development of investible, proprietary indices that track
related strategies across a range of asset classes.

Unlike
existing benchmarks in this asset class, the E8 Index focuses exclusively on
the largest eight EM countries and invests in three month FX forwards and NDFs,
something that minimises the duration risk of the portfolio.

The eight
emerging market currencies included in the E8 Index are Chinese yuan, South
Korean won, Indian rupee, Mexican peso, Brazilian real, Russian ruble, Turkish
lira and South African rand.

“The E8
Index fills a much needed gap in the market as investors increasingly want to
capitalise on the opportunities presented by EM economies,” says John Bennett, global
head of FX at NAB.

Simon Ho,
CEO at T3 Index believes that as a pure FX product, the E8 Index helps to
alleviate the duration risk associated with investing in bonds. “
I am
not sure, as we enter a rising interest rate environment, that investors want
to be exposed to duration,” he observes.

Ho says that the E8 Index differentiates itself by focusing
on the top eight emerging market economies and having weightings that reflect
that. “There are indices or ETFs that are equally balanced across the countries
in the basket, but that has the drawback of not reflecting the increased
influence of, for example, China,” he says. “This is because there is no direct
access to the Chinese bond markets for offshore investors, with the E8 Index
China has a 42% weighting and because we are using the offshore, non-deliverable
market we can provide that access.”

The weightings of the individual currencies in the index are reviewed annually
and are adjusted according to
changes in FX turnover, GDP and trade statistics. Initially, in addition to
China, Mexico will be weighted at 12%, South Korea at 11%, India at 9%, Brazil,
Russia and Turkey at 7% and South Africa at 5%.

“We wanted to avoid markets that can be difficult to invest
in, such as Malaysia,” Ho explains. “We also wanted to move away from the equal
weightings approach and reflect the different economies’ influence.”

Probably the closest comparison to the E8 Index is found in
the EMLC ETF, created by VanEck Vectors and based upon the JP Morgan Emerging
Market Local Currency Bond Index. Aside from the aforementioned issue of longer
duration risk, Ho says that results from the E8 Index are broadly similar to
those from the EMLC ETF, however with half the volatility and drawdowns.

Over a seven year period the two indices have a 92%
correlation, yield of 4.9% for the EMLc ETF and 4.5% for the E8 Index, however
volatility of the E8 is 5.1%, compared to 10.6% for the EMLC ETF and drawdown
is -15%, compared to -32%.

For each
currency T3 produces a sub-index which represents the return from investing US
dollars into the local currency. Two tranches, out of phase by one month, are
combined with each tranche investing in a three-month FX forward contract and
rolling with one month to expiration. This ensures maximum liquidity and helps
to diversify against event risk,” Ho says.

The data
for the E8 Index is provided by TP Icap, it is accessible from both Bloomberg
and Thomson Reuters services.

The new index
is intended to be the first in a family of EM FX benchmark indices to be launched by T3 that will include
regional sub-indices and volatility series over these benchmarks. “
Our
speciality is volatility so we are overlaying a volatility series for the
indices,” says Ho. “This will be on a regional basis to allow investors who
don’t want broad exposure, access to target a particular region.

“The vol series will also be regional because of
geographical obstacles – namely liquidity conditions for Latam currencies
outside the local window are thin and the same goes, to an extent, for Asian
currencies,” he adds.

Looking ahead, Ho is optimistic of interest from ETF
providers, however he stresses the initial object is to establish the index and
proving its worth. “I also see potential interest from pension plans who want
to invest in these places in a seamless and simple fashion,” he explains. “I
also think there are opportunities for traders down the line, something that
offers realistic access to these markets.”

“We are
really excited about the E8 Index because it overcomes the many barriers to
investing in emerging markets,” Ho continues. “This Index provides a simple,
liquid and transparent way for global investors to gain exposure to the core
eight EM countries in a single trade.”

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Twitter @Profit_and_Loss

Colin Lambert

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