This calls into question the treatment of “foreign investors” as a unified investor category; not only do EM funds themselves have different investment mandates, but there are multiple sub-classes of foreign investors, who may have widely differing attitudes to risk, and behaviors. For the debt manager, it is likely to be increasingly important to differentiate in a systematic way amongst foreign investors, since assessing the category as a whole may not yield accurate insights into the behavior of different classes of offshore participants in the debt market.

Amongst asset managers benchmarked to EM domestic debt indices such as the JP Morgan GBI-EM, there is a spectrum of approaches running from index-tracking, passive investors, to active managers with large permitted index tracking errors. A notable recent development has been the growth of exchange-traded funds (ETFs) tracking EM local currency bond indices. Two examples are the iShares Emerging Markets Local Currency Bond Fund, launched in October 2011 and benchmarked against the Barclays Emerging Markets Broad Local Currency Index, and the SPDR Barclays Capital Emerging Markets Local Bond ETF, launched in February 2011 and benchmarked against the Barclays EM Local Currency Government Diversified Index. Both funds are listed on the NYSE. ETFs such as these provide investors, including retail investors, with exposure to an entire EM bond index at low cost, potentially significantly boosting investor access and interest.

Beyond EM-dedicated investment funds, including ETFs, a first additional foreign investor category to consider is official sector investors, comprising:

- i. Central banks. Global central bank reserves remain heavily concentrated in US dollars and Euros, but as reserves continue to grow and some diversification continues, demand from central banks for EM local currency debt instruments (including bonds) looks likely to rise. Total reserves allocated in “other” (non-traditional reserve) currencies, recorded by the IMF’s COFER database, stood at US$294 billion as of Q1-2012. This is an order of magnitude higher than the US$22 billion recorded in 1999, but still represents just 5% of the total allocated amount (Figure 7). Total global reserve holdings, including unallocated reserves not included in the COFER data were approximately US$10.4 trillion as of Q1-2012.

- ii. Sovereign wealth funds (SWFs). SWFs have also grown rapidly and had assets of around $4.6 trillion as of Q1-2012.<sup>10</sup>

Given their size, allocations by central banks and SWFs to local currency EM bonds need increase only very slightly to boost demand significantly. EM central banks may themselves drive this trend, as EM reserve assets continue rising and “south-south” trade linkages grow.

A second additional investor category is absolute return investors: global hedge fund AUM stood at about US$2 trillion at the end of 2011, following net inflows for the year of US$70 billion.<sup>11</sup> Hedge funds’ aggregate allocation to EM debt is hard to gauge but significant. As of Q2 2012, one estimate placed EMdedicated hedge fund AUM at US$203 billion (though this includes allocations to EM asset classes other than bonds, notably equities); macro hedge fund AUM was estimated at US$173 billion (a portion of which is allocated to EM debt).<sup>12</sup> Increases in liquidity as debt markets continue to develop may attract more trading-oriented, leveraged investors.

A third additional investor category is benchmarked funds which have not traditionally focused on EM debt, but may increasingly begin allocating at least some assets to this area. The drivers of such fresh allocations include:

- i. Adjustment of funds’ investment mandates to incorporate benchmarked EM debt exposure;

- ii. Funds making permissible off-index asset allocations to gain exposure that is determined to be

> 10 Source: Preqin

> 11 Hedge Fund Research Inc., _Hedge Fund Investors Rotate into Macro, Arbitrage Strategies for 2012_ (Press Release, 2012)

> 12 Source of numerical estimates: BarclayHedge

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