FUND MANAGEMENT: Fool’s gold?
Emerging markets continue to lure institutional investors looking for yield in a low-return world. But for some, there is just too much hype around the asset class
In September the US Federal Reserve unveiled plans for another monetary stimulus. By the end of the week of that announcement, inflows into emerging market equity funds soared to $4.3 billion, according to EPFR Global, the fund tracker. This was a steep rise, compared to the previous week, when inflows stood at $447 million. Emerging market bond funds also saw a sharp rise of $1.4 billion in fresh capital, according to news reports.
Critics have voiced concern that investors commitment to emerging markets is temporary, buoyed by uncertainty in developed markets. They argue that the asset class is volatile, and not suitable for institutional investors. But, if the figures are anything to go by, investors seem to disagree.
There is a great deal of institutional appetite for emerging markets at the moment. A few years ago, institutional investors were really underinvested in emerging markets, compared to their weight in equity indices. But in the past few years they have realized that emerging markets are too big to ignore, and they are increasing their allocations, says Michele Aghassi, co-head of research in the stock selection group at AQR Capital Management, the systemic manager.
Despite this, allocations remain limited. Many institutions will have an allocation approach that mimics market indices. But the majority of these rank countries and stocks according to their market capitalization, without factoring in either current or future economic activity. Within the MSCI All Country World Index, which is one of the primary benchmarks of world equity representation, developed markets still account for close to 90% of the index, compared to only 10% for emerging markets, says Jean-Paul Kachour, head of Asia ex Japan in the external equities department at the Abu Dhabi Investment Authority (ADIA).
A significant amount of investor appetite revolves around debt. Investment consultancy Mercer interviewed 1,200 pension plans in 13 European countries, which represent assets of approximately 650 billion. It found that both in the UK and in continental Europe, emerging market debt was one of the most popular asset classes in terms of strategic allocations to alternative assets. In the UK, 20% of funds have an emerging market debt allocation. In Europe, around a third of institutional investors have invested in emerging markets debt. Such allocations are predicted to rise, as investors need to diversify their bond exposures from traditional sovereign safe haven debt.
According to estimates from JP Morgan, emerging market public debt stands at approximately $7.3 trillion, which is more than triple what it was in 2000. Corporate debt is about $1 trillion. Still, these figures pale in comparison to developed markets. The US bond market stands at over $35 trillion. But growth in emerging markets has been substantial. The output of emerging markets in 2010 was nearly 40% of world GDP. It is expected that this percentage will be more than 50% by 2020, according to a white paper published by Clear Path Analysis.
Currently, investors have more funds allocated to hard currency bonds than they have to local currencies. In the first six months of the year, global emerging market debt funds attracted the most new money out of all assets, 12 billion, with a further 4.1 billion in local currency funds, according to Lipper, the supplier of mutual fund information.
Institutional demand over the last year and a bit has been in favour of emerging market sovereign dollar bonds. This is part of the financial repression of markets; you can invest in a fixed-income asset that has some yield pick-up for Treasuries, with a reassurance of repayment. Thats certainly why institutional investors have been piling into emerging markets external bonds, says Julian Adams, chief investment officer of Adelante Asset Management.
But local currencies are interesting at the moment, he adds. In our portfolio we allocate dynamically between external bonds and local currency bonds. A lot of the yield compressions weve seen in the dollar bonds have played out. Investment-grade bonds are starting to be overbought. Ten-year Mexican bonds in dollars are yielding 2.5%. When the Fed normalizes the interest rate market in the US, this will be under water. So a lot of the opportunities in external bonds have played out, and there are more opportunities in local currencies, he says.
Alexander Kozhemiakin, director of emerging market strategies and senior portfolio manager at Standish Mellon Asset Management, says he is overweight the Mexican peso, which he believes is undervalued by about 15%. However, he argues that investors need to understand the different exposures they have to debt. We have to do a lot of educational work with investors. They see emerging market debt as one asset class, but it is not. There are dollar denominated bonds, and local currency bonds, which are a completely different animal. Their return and risk profiles are different. Dollar denominated is lower risk and lower return, whereas local currency has the potential to generate higher returns, but you have equity volatility of 1020% on an annualized basis. The third approach is to combine dollar and local currency debt, he says.
A combination of the two is the best approach, says Mark Horne, a consultant at Towers Watson. We have for a number of years recommended that our clients invest in a balance of hard and local currency bonds. We think that is the best way to capture all the different dynamics of the market.
Horne feels that investors should rethink the way they approach the asset class. The dividing line between developed markets and emerging markets is getting more and more blurry. The average credit quality of emerging markets is now investment grade, and we have every reason to believe that this trend will continue in the long run.
He also believes investors should have a more integrated approach to emerging markets. It seems strange to have a dividing line between, say, Italy and Taiwan that is arbitrary. It would be much more interesting to have a portfolio that really looked across the world at relative value across the board.
Thats well and good, but some critics believe that institutional investors need to remain wary, particularly when investing in equities, unless they are using emergingmarkets for opportunistic investing. Emerging markets have proved to be far more volatile than developed markets. China declined by something like 88% in 2008, and if you look at the last six months, China is down by 18% or so. Investors are hesitant to invest in markets which are so volatile. More investors are saying that if you want to buy the China story, why not buy General Motors stock, because that has a large exposure to China. At least that way, you can be sure that there is governance and transparency, says Amin Rajan, CEO of Create-Research, the independent global forecasting centre.
In July, global emerging markets were easily the most popular equity sector in terms of inflows, according to Lipper. The asset class saw flows of 550 million.
Rajan says the governance issue is a major hurdle for emerging markets. What does it mean to buy a stock of a government-owned bank in China today? How much can you believe in those numbers? A lot of these banks have a huge amount of bad loans. On any criteria, Chinese banks should not be valued as high as they are. Trustees have reputational risk to worry about. Their own necks are on the line, so they have to have a strong stomach to ride out the roller coaster of that market, he says.
It is an argument that irks Jerome Booth, head of research at Ashmore Investment Management, who points out that on the debt side at least, emerging markets have proven to have the same or less volatility. Equities will always remain volatile, partly because they are linked to the developed world. But if your motive for buying emerging markets is to reduce risk, then General Motors will not help you. GM is a bankrupt company, and any multinational company with enough liabilities in Europe and the US is a problem. In 1929 US stocks lost over 80% of their value and went through a depression. China fell 88%, but who has got the debt problem today? Who has got the overhang?
Booth also points out that banks are only one part of the Chinese economy. I find it really amazing that people are still coming up with arguments that are not macroeconomics. Because they have a banking problem, a whole country is written off. Nonsense. There are problems which are specific, and problems which spread across the whole of an economy and are difficult to deal with. China has none of the latter, but the UK and Europe do.
He also points out that emerging markets are broad and offer opportunities across the risk spectrum. Investors can take their pick. Currency plays are gaining traction, according to Record Currency Management (RCM), which manages $30 billion in emerging market and developed market exposures for institutional investors. We typically find that for equities, anything from a third to a half of the return comes from currency exposure, and for bonds that may increase to 80%. So currency is a very significant contributor to equity and debt returns for investors, says James Wood-Collins, CEO of RCM.
SPOILT FOR CHOICE
Investors can use currencies in many ways. One is as a pure return-seeking allocation to an emerging markets currency strategy. A second approach that probably lends itself better to larger, more sophisticated investors is the recalibration approach. Lets assume that you as an investor have already made investments in emerging markets bonds. The currency return you are getting from that strategy is simply a function of the countries in which your bond managers have made investments. We can run an overlay, through which we reweigh exposures on a basis that we think is going to produce a better risk-managed currency return, rather than simply following the underlying bonds. Finally, we see emerging market currency as an attractive route by which to implement an emerging market local currency debt strategy, Wood-Collins explains.
Horne says there are regional opportunities as well, as over the long term one would expect emerging market currencies to increase in value and developed market currencies to decrease in value. As we looked across the marketplace we found that there were plenty of emerging market currency hedge funds, and there were some long-only emerging markets currency managers charging 80100 basis points for long-oriented strategies. They were often carry-oriented, for example focusing on Latin America, which was not what we were looking for.
We identified more semi-passive currency managers, who are inexpensively priced and more skewed towards Asian currencies. This is where we think the biggest opportunities are: we expect a gradual increase in these currencies over time. One of the important aspects of the strategy is that it is not just funded from the dollar. It is short the dollar, the euro, the yen and the pound, which reduces the volatility of the strategy. We call it smart beta.
For investors that do want higher yielding, higher risk assets, sovereign bonds in frontier markets are generating excellent returns. The Ivory Coast has returned 68% in the year to September, Senegal 22% and Pakistan 20%. There is still a preference for liquidity, which is a function of the global environment. That is still weighing on investors minds. The challenge with frontier markets is that they tend to be smaller and less liquid. Bond issues are fairly small. It could be difficult to write $100 million tickets in some of these countries without moving the market. That is one constraint, put into focus by the fact that the pool of capital looking at emerging markets is still bigger than the supply of paper, says Stuart Culverhouse, chief economist at Exotix, the boutique brokerage dealing with frontier markets.
Whatever the allocation decision though, one thing is clear: emerging markets are high on institutional investors radars now. As debt in developed nations mounts, allocations will only increase.