INSTITUTIONAL INVESTMENT: Into the breach
GlobalMarkets, is part of the Delinian Group, DELINIAN (GLOBALCAPITAL) LIMITED, 4 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 15236213
Copyright © DELINIAN (GLOBALCAPITAL) LIMITED and its affiliated companies 2024

Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement
Emerging Markets

INSTITUTIONAL INVESTMENT: Into the breach

ap10060407010-rail-tracks-100x100.jpg

Why emerging markets can’t defuse the pension time bomb in the West

 

In the grip of the global crisis, investors gasped as a decade’s investment gains were wiped out in 15 months. The catastrophic crash – triggering $15 trillion of losses in global asset values, according to Citigroup Principal Global Investors – has set off an existentialist crisis in western asset management. Investors, who were saddled with huge losses before last year’s rally, are reassessing investment principles from bonds versus equities, active versus passive asset management and asset class correlations.

While the financial community is divided over portfolio strategies, one unifying theme is the allure of emerging markets. A benign consensus has emerged that developing markets – with their growing economies, populations and incomes – offer western asset managers an opportunity to grow capital through high returns. A survey by Baring Asset Management says a push to invest in emerging markets has yet to run out of steam, despite the rally since last spring that has squeezed valuations.

A survey in August found that 67% of 136 investment professionals said clients should increase emerging market exposures over the next year. The asset class comes on top of natural resources, multi-asset funds, developed world fixed-income products, and absolute return strategies.

The findings come after Boston Consulting Group’s (BCG) annual asset management survey in July found that last year assets under management rose by 11% in North America, 12% in Europe, 7% in Japan and Australia, 25% in the rest of Asia and 22% in Latin America. BCG researched 34 markets, which represent more than 95% of the asset management market, and concluded that emerging markets could account for 25% of the growth in new assets under management between 2010 and 2014. “We expect Asia-Pacific, excluding Japan, to grow at nearly twice the global rate, raising its share of global wealth from 15% to 20% in 2014,” says Tjun Tang, a Hong Kong-based partner.

Seduced by the resilience of Asia’s business cycle, growing domestic consumption in Latin America and petro-dollars in the Gulf, western asset managers have woken up to the emerging markets potential. Fixed income and equity funds pulled in almost $80 billion between January and end-August, according to the Institute of International Finance (IIF). Institutional and retail investors are fleeing US money market funds and developed world equity funds in favour of emerging economies.

 

BABY BOOMERS EXPECT

The elevation of the emerging market potential coincides with the retirement of the baby-boomer generation. European and US pension funds are wrestling with providing retirees with stable incomes – in a market still struggling with the biggest crisis since the Great Depression. Unfunded liabilities in EU member states – the difference between projected cost of government social policies, principally retirement and benefit costs, and net expected tax revenues – reach an average 434% of GDP. And it’s not just public or European pension funds in the red. According to management consultancy Mercer, the aggregate deficit for S&P 1,500-listed companies in the US, reached $451 billion in June, 26% short of aggregate liabilities. The ascent of emerging markets and the financing power of developed world pension funds conjures up a tantalizing prospect: a surge of investment into the East, turbo-charging emerging market growth, while providing retirees in Europe and the US with lucrative returns.

“The crisis has highlighted the division of the world into a developed world struggling with ageing populations and a high debt burden and the developing world with younger population and higher growth,” says Erik Valtonen, chief investment officer of the Third Swedish Pension Fund (AP3), with Sek11.4 billion invested in emerging equities. “We are seeing increasing pension fund interest into emerging market equity and debt,” he says, with Sek208.6 billion of assets under management.

This trend has gathered pace. Earlier this year, ABP announced a shift to take on more risk because its liabilities are higher-than-budgeted. The fund, which has over E200 billion in assets, will cut its holdings of developed markets equity in favour of emerging markets, commodities, infrastructure and real estate as well as inflation-linked bonds. The Dutch Algemene Pensioen Groep NV, which manages E250 billion, plans to increase its real estate investment in Asia by E1 billion over three to five years, as it seeks to benefit from the region’s economic growth, principally China and India.

Calpers, the largest public pension fund in the US with $200 billion in assets, is estimated to have lost $70 billion in 2008 and 2009. Thanks to disastrous bets on US stocks and real estate, it has earned an annualized 2.88% return over the past 10 years, far below the 7.75% it must collect every year to meet its obligations to its 1.6 million clients. A Stanford University study in April said Calpers’ unfunded liabilities represent 50% of its assets.

Calpers is soul-searching as it mulls the trade-off between risk and reward. An asset allocation review is due at the end of the year. As of June 18, 2009, the fund had $4 billion in emerging market equities, just 2% of its total assets, underscoring the potential for western funds to hike emerging market exposures given the low base.

The top 200 US defined-benefit pension funds, worth $3.5 trillion, are structurally underinvested with just 2% of assets invested in emerging markets, says Nick Chamie, global head of emerging markets research at Royal Bank of Canada (RBC). So can high returns from emerging market bonds and stocks help defuse the pension time bomb?

RISK FALLACY

For Amin Rajan, chief executive of Create-Research, a pan-European network of researchers, the idea that western pension funds will commit sums to emerging markets is laughable. “Are you kidding? It’s a fallacy that investors are going to chase more risk.”

The old trade-off between risk and reward was savaged by the volatility and illiquidity in the global crisis. The investment landscape is linked with unprecedented economic uncertainty that is triggering clients to rebalance portfolios in favour of low-risk assets and confining risk to the periphery of benchmarks, he says. By the end of the decade, 60% of pension fund clients in the West will be retired, which will force them to generate income and protect the principal. This will require funds to maintain rising cash flows to dish out pensions.

Richard Lacaille, global chief investment officer of State Street Global Advisors, says retirees are naturally more risk-averse, but funds need to generate solid income streams due to longer life expectancy. “There was a time when investors would rely on fixed annuity schemes, but fixed-income returns in the West are so low that they will have to invest in riskier assets, such as emerging markets.”

Jeremy Paulson-Ellis, consultant to equity-focused Genesis Asset Management, says emerging market equities must form a core part of any pension fund’s portfolio. “If pension funds just invest to match their assets with liabilities and concentrate on domestic dollar-denominated fixed-income assets, the returns will be extraordinarily low and they will not be able to meet their return targets.”

Pension funds can still pursue dynamic asset allocation strategies that blend conservatism and opportunism, says Lacaille. “If a pension fund has increased its expected return as a result of investing in emerging markets, it has the flexibility to reduce risk in the core of its portfolio and take on more risk in the periphery. Emerging markets will represent a small number of assets that deliver much more over Libor,” he says, referring to the ‘barbelling’ effect that allows one portion of the portfolio to achieve high yields while the other portion minimizes risk.

ATTRACTIVE ALTERNATIVES

Many pension funds in the West have split their portfolios between liability-driven investments that generate low-cost beta, which are less volatile assets such as government bonds, and a portfolio of investments that aim to deliver market-beating alpha.

For example, since 2004, Denmark’s ATP, with $74 billion of assets, divided its assets into a liability-driven fund, creating a hedged portfolio that invests overwhelmingly in government bonds and interest rate swaps, and smaller investment funds that chase risk. Thanks to the stability of these investments, ATP has funded its liabilities to the tune of 158%, as of September 2010, which has given it the firepower to beef up its alternative investments. ATP has E700 million of emerging market debt, which could be doubled in the next five years if it continues to outperform G7 markets, without causing a reassessment of its risk exposures, says Anders Svennesen, ATP vice-president.

But emerging economies were always supposed to deliver lucrative returns. Now developing economies – with their greater share of the global wealth and relatively healthy banking systems – represent something more profound: the potential to form a strategic part of a pension fund’s investment horizon. Emerging markets serve as a risk diversifier and “a hedge against a double-dip recession in the US”, a sovereign debt crisis in Europe, or a “collapse of the US dollar”, says Jerome Booth, head of research for Ashmore Investment Management.

Yet emerging markets’ reputation as a hedge against a developed world crash failed the global stress test. In the 2008 crash, stocks, bonds and currencies in the emerging world drastically underperformed. From their peaks in October 2007 until the March 2009 rally, mature equity markets fell by 59%, or $19 trillion, as measured by the MSCI World Index. Emerging equity markets lost more in percentage terms at 64% or $4.3 trillion in market value. Hard currency emerging market bond spreads widened from 240bp before the 2008 collapse of Lehman Brothers to 700bp. By contrast, spreads for European and US government paper fell dramatically due to their status as safe havens.

Says Rajan: “In every downturn since the 1990s, the collapse of world markets has triggered massive underperformance in emerging markets. This has not gone unnoticed by western pension funds.”

Svennesen says the fear of selling positions in a falling market underscores why “emerging markets will always be substantially more dangerous than the European bond market.”

EQUITIES TAKE A TUMBLE

Crucially, equities, across the developed world, have taken a knock in the crisis, as the asset class in the first decade of the 21st century flopped, with the MSCI World Index generating flat returns, according to the Credit Suisse Global Investment Returns Yearbook 2010. In keeping with stricter European pension regulations designed to mitigate risk, equity allocations of defined benefit schemes in the UK have fallen from 54% in 2009 to 50% in 2010 and from 28% to 23% in the Netherlands, according to Mercer’s annual European Asset Allocation survey released in April.

This trend is gathering pace, with 35% of European schemes (ex-UK) planning further reductions in domestic equity and a further 33% of European schemes (ex-UK) planning a reduction in non-domestic equity.

Pension funds will no doubt increase their emerging market stock investments because it’s from such a low base. But the bigger question is whether emerging equities can form a strategic part of a portfolio. Hanna Hiidenpalo, chief investment officer at Finland’s Tapiola Pension fund, typifies the risk appetite of Nordic pension funds. The fund, with a total E9 billion, has 10% of its assets in emerging markets and is seeking to increase its exposures due to “their growing economic prospects”, she says. Developing market stocks “are becoming more and more a strategic part of a long-term pension fund portfolio due to growing economic prospects.”

But in the main, the asset class will remain an opportunistic play, designed to generate market-beating returns at the periphery of a portfolio, rather than a strategic part of its buy-and-hold investments, says Rajan. His conclusions draw from an independent study he conducted, commissioned by Citi’s Principal Global Investors, which surveyed the opinions of mainstream institutional investors with $1 trillion of assets.

Although emerging equities have generated an annualized return of 10% over the past decade, according to Credit Suisse, any push to emerging market stocks sits awkwardly with tough liquidity rules among pension funds. These funds are heavily regulated and required to mark-to-market their assets daily, forcing rapid divestments if assets fall in relation to liability thresholds. This is a blow to emerging market exposures, given the illiquidity and volatility of many of these markets.

What’s more, pension funds have adopted tough liquidity rules in the post-crisis landscape. For example, ATP can only invest in assets where allocations can be reduced by 30% within two weeks. This rules out many emerging stock markets that lack the market infrastructure and liquidity to conduct quick trades.

Emerging market bonds have provided a superior return in risk-adjusted terms compared with G7 markers in from January 1995 to August 2010, according to RBC. Hard currency sovereign bonds have posted an annualized return of 12% with a standard deviation, as a measure of risk, the lower the better, of under 13. Meanwhile, the Merrill Lynch index of high-yield bonds has a lower unit of risk at eight, but returned just 6% annually.

Despite the hype surrounding emerging markets and non-OECD (Organization for Economic Cooperation and Development) economies now representing half of global GDP, they can’t serve as a target for pension funds. There is a lack of investable fixed-income assets. In Asia, Latin America and EMEA (Europe, the Middle East and Africa), emerging equity markets are much larger than debt markets, reflecting their lack of leverage.

According to Bank of America Merrill Lynch, the full-float of emerging Asian equities was worth $10 trillion while bonds in the region were worth $5 trillion last year. By contrast, the figures in the US were $13 trillion and $35 trillion. Hard currency emerging market bonds are worth $1.5 trillion, just 2% of the total bond asset class, according to JP Morgan. Meanwhile, local currency emerging market debt represents 10% of the bond world at $8 trillion while the US Treasury market is $6 trillion, according to the Bank for International Settlements.

However, just $1 trillion of local currency debt is easily accessible to foreign investors as the largest markets, principally India and China, operate capital controls, reckons David Spegel, global head of emerging markets strategy at ING.

SILVER LINING

The main beneficiaries of Asia’s stunning growth then are specialized emerging market investors, local pension plans, retail savers and banks. Of the 58% of mainstream institutional investors, representing $1 trillion of assets combined, who see Asia as a source of growth, only 10% see it as the “dominant” source of capital gains, according to Rajan.

Fund growth in China’s two flagship liberalization measures, Qualified Foreign Institutional Investor (QFII) and QDII, for domestic investors, has been restrained to cool capital inflows and renminbi strength. As of March 2010, cumulative assets covered by official quotas were $70 billion in QDII and $35 billion in QFII. The numbers pale compared with even the more conservative estimates of the combined market potential of $1 trillion.

Many investors choose to invest in Asia through Hong Kong-listed stocks or punt on China proxies in the form of commodity-focused corporates, from Latin America, south-east Asia or the West. However, pension funds’ direct allocations to the emerging markets will only move at a snail’s pace in the post-crisis era where equities and risk are no longer in vogue.

Nevertheless, the silver lining, as Robert Parker, senior adviser to Credit Suisse and chairman of the Asset Management and Investors Council of the International Capital Market Association, notes, is significant. “The lack of substantial western pension fund money in emerging markets will help by not adding to the wall of money – which is leading to fears that valuations are getting stretched – hitting these markets.”

Gift this article