Investment Manager:

Citadele Asset Management

(February 2012)

How has the Fund performed recently compared to its peers and are there any particular stocks or areas where the Fund is performing well?

During the last month (January) the Fund has demonstrated very solid performance, gaining 4.3% in USD terms.

Emerging market (EM) sovereign bonds have long been seen as ‘riskier’ than those issued by developed market nations. Is this opinion changing among investors in light of the Eurozone crisis?

Expected EM growth of 5.7% in 2012 and 6.3% in 2013 compared to growth in developed markets of 1.1% and 2.0%, respectively, highlights the relative strengthening of the EM segment. Meanwhile, as the fiscal positions in developed countries highlight their debt burdens, the solid fiscal fundamentals of emerging markets are likely to result in further ratings upgrades as they remain relatively resilient and better positioned in comparison to developed market peers. We have already observed that this is improving the perception of EM sovereign risk.

The Fund invests in both corporate and sovereign bonds. Do you divide investments between each equally or is there a greater weight towards one or the other?

In the local currency segment, where our management style is more top-down, the majority of investments are in sovereign, or equivalent, securities, representing the nature of the market. However, our investment approach to EM hard currency debt is pronouncedly bottom-up, and our screening and valuation process systematically favours corporate over sovereign issues in the hard currency segment. As a result, just over half of the Fund (50.1%) is invested in sovereign debt at the moment [as of January 31]. We do not have any specific target per se for this, but it is also clear that at 50% this is at the lower end of the possible range.

What factors do you take into account when deciding on the portfolio’s geographical allocation?

While our investment process, especially in the hard currency universe, has strong bottom-up characteristics, the overall geographical allocation of the Fund is important. When addressing geographical allocation we take into consideration multiple factors - growth and fiscal expectations, business, rating and default-cycle expectations, as well as our in-house historical and credit-rating based valuation scores that offer valuable guidance.

Have there been any emerging markets or specific regions whose bonds have historically performed better than others and if so, why?

Emerging market regions are not homogeneous in terms of their risk. For example, historically, Asia outperforms in market downturns, while Latin America and Eastern Europe outperform during rallies. As a result, it is impossible to generalize and highlight any region with historically better long-term performance compared to others. Nevertheless, there are few market inefficiencies in emerging market debt that hold for a prolonged period of time, resulting in mispriced assets and creating attractive investment opportunities. For example, Russia’s quasi-sovereign Eurobond Gazprom’18 historically trades with up to a 150bp premium over a comparable bond issued by Brazil’s quasi-sovereign Petrobras, although both companies operate in the oil and gas industry and have a similar composite rating of BBB. This probably has something to do with American investors’ home bias. Unbiased investors with a medium to long-term investment horizon are able to take advantage of this and similar arbitrary investment opportunities.

Some emerging markets are classed as ‘frontier’ markets. What investment opportunities are offered by frontier markets as opposed to other EMs and are there any risks connected to frontier market investing to be particularly aware of?

Frontier markets are markets that are generally underdeveloped and fragmented, i.e. there are very few issuers and instruments available, just as there are a very small number of dedicated investors. These traits naturally mean instruments having lower liquidity and often, though not always, lower transparency and corporate governance standards on the part of issuers. Along with these higher risks, however, the potential rewards are much greater than in the more developed echelons of emerging markets and because of much smaller coverage, a dedicated investor can often spot very attractive deals. The Fund has some, though not many, investments in what might be classified as “frontier” markets, and we are continually monitoring these markets for new opportunities.

The Fund invests in both hard and local currency instruments. What investment advantages does this provide?

Our Fund has the advantage of offering exposure to the complete range of EM debt market segments from hard currency sovereign and corporate to local currency debt. Our investors do not need to worry about or continuously monitor what are often swiftly changing EM markets to see if EM sovereigns or EM corporate, or EM hard currency or EM local debt is more appealing at any given time. We monitor all of relevant events and market moves to deliver those decisions in the final product. As a result, if an investor believes in the case for EM debt structural outperformance in the medium-to-long run, as we do, our Fund is well suited to their portfolio.

To what extent is the rapid GDP growth in emerging and frontier markets linked to the performance of securities?

Emerging markets are indeed poised, in our opinion, for medium-term structural outperformance in terms of economic growth vis-a-vis developed markets. This is based on demographic trends, institutional developments and macroeconomic and fiscal fundamentals that offer EM policymakers larger room for policy development than their counterparts in developed markets. While news and events in developed markets (especially the Eurozone recently) continues to affect security prices in EMs, making them less driven by local dynamics, I would argue that this is now much less so than it has been historically, e.g., compared to 2008. The EM market landscape is changing and there are grounds to believe that over the medium term this “separation” will increase further. First of all, the size (market cap) and liquidity of EM debt markets has been rapidly growing during the last 5-10 years. Secondly, EM debt is increasingly being treated as a stand-alone asset class by global asset allocators, also establishing more stability on the demand side of markets. The number of dedicated EM debt funds at global asset management companies has also mushroomed, supporting this notion. Finally, the rapid growth of domestic institutional investors in the emerging world (sovereign wealth funds and pension funds) further contributes to the stability of demand for EM debt. As a result, we expect that over time it will be increasingly local factors that determine returns of EM debt.

As correlation between markets continues to intensify in an increasingly globalised world, to what extent does portfolio diversification still benefit investors?

The strength of correlation tends to change over time and in different market circumstances. As a result, the importance of diversification per se for long-term investors has not declined, in our view, and especially holds true in portfolios with higher risk assets, including emerging market debt. For example, the average credit rating of the Barclay’s Capital Global Emerging Markets index, representing the hard currency universe of EM debt market, has an average credit rating of Baa3/Ba1, which indicates that roughly 5% of the investment portfolio could default over a 5-year period, according to Moody’s historical data. As a result, investors holding less-diversified portfolios are significantly more exposed to potential default cases that could lead to severe loss. Even if we exclude extreme scenarios of defaults, putting all money in one or a few assets in emerging markets is a very risky strategy as issuer-specific risks in these markets are significantly higher than in the developed world. All in all, diversification remains a crucial characteristic of investment strategy in emerging markets. Hence, well-diversified dedicated mutual funds provide the best exposure to the market for individual investors.

Hypothetically, if you were an investment manager building a portfolio for a client, what proportion would you advise to be set aside for emerging market bonds?

In a hypothetical case, I would definitely allocate around 15-20% to EM bonds in a conservative bond-only portfolio and up to 50% in a more aggressive portfolio. The EM bond exposure would be equally split between hard and local currency bonds, while in the hard currency space I would opt for a more conservative allocation – corporate Eurobonds with at least a BB rating and a maturity of up to 5 years.

How do you see the EM debt market developing over the next six months?

In general, we expect higher-yielding (i.e., non-benchmark) fixed income assets to perform well in 2012 given the combination of factors in the developed world, but for EM debt this expectation is further supported by positive local fundamentals. Apart from expected economic outperformance, the rating cycle is still positive in EMs and is very likely to continue in 2012. This is not being reflected in bond prices, especially in the corporate segment. The supply/demand structure is also expected to be positive for 2012 for EM debt, especially in the sovereign space, where new issues are expected to match, at best, the amount of redemptions and coupon payments. While the overall setting for EM local currency debt also appears supportive with monetary easing cycles in EMs just started, we see risk-rewards as more attractive in hard currency paper at the moment as local currency dynamics versus USD have been disproportionately affected by disappointing events in the developed world and there is a risk this may persist in 2012. Subsequently, for 2012 we have a neutral stance on local currency debt, but a positive stance on EM hard currency sovereign and (especially) corporate debt.

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