Emerging markets and local authority pension funds

Written By: Matthew Craig LAPF Investments

Growth and diversification are two of the main reasons for investors to consider an allocation to emerging market equities, but these qualities are not always consistently delivered. Just as an investor would have loved to have held Apple or Microsoft when they were barely known, so he or she looks to benefit from the rise of countries such as Brazil, China and other emerging economic powerhouses. But the normal rule of investing is the greater the potential for gains the bigger the risks, and emerging markets tend to illustrate this. Terms such as “volatile”, “roller coaster ride” and “not for the faint hearted” are frequently tied to the emerging markets. For instance, Nigeria was the best performing emerging market in 2007 with a 108% return, but in 2009 it was the worst performer, down 36%. Egypt did something similar: up 158% in 2005, but down 50% in 2011 as the Arab Spring took place.

Over the last twenty or so years, the likes of Brazil and China have gone through an economic and industrial transformation based on factors such as cheap labour, a rural to urban population shift, access to natural resources and the emergence of a middle class. But the global financial crisis caused a slump in asset values worldwide, which hit emerging market equities badly. Since then emerging markets have struggled somewhat. Schroders head of emerging market equities, Allan Conway, commented: “Global emerging markets (GEMs) have underperformed developed markets for the past three years due to a combination of weaker-than-expected economic growth and earnings, a strong dollar and more recently, concerns over the potential ramifications of policy stimulus tapering in the US.” PAAMCO managing director, Alper Ince, said: “Emerging markets are in an interesting spot; the big global macro hedge funds are shorting emerging markets versus Japanese and US equities – that’s the consensus trade. Fed tapering concerns are impacting emerging markets, especially those countries with current account deficits.”

As Ince says, many investors are concerned about the effect that the Fed’s tapering of quantitative easing will have which could be early in 2014. When Fed chairman Ben Bernanke first mooted the idea of tapering in May 2013, countries such as India, Brazil, Turkey, Indonesia and South Africa saw a fall in their asset valuations. This has been attributed to a concern that some emerging markets, particularly those with current account deficits, look vulnerable if liquidity is tightened. Pictet Asset Management chief strategist, Luca Paolini, said: “In emerging markets, valuations are especially compelling as stocks are trading at a 24% discount to their developed counterparts on a price-earnings basis. Our preferred markets are China and Russia, where valuations are especially attractive.” Paolini added that Pictet remains cautious on countries with significant economic and financial imbalances, such as Turkey and South Africa.

From an investor perspective, West Midlands Pension Fund director of pensions, Geik Drever, observed: “Emerging markets assets generally have suffered in the last few months from liquidity outflows, and there is a risk that there will be further outflows when the Fed ends QE in due course. We think that whilst the short-term outlook is uncertain, the longer-term prospects are favourable, underpinned by increasingly attractive valuations. How individual funds position themselves depends on a range of factors, including their time horizons, risk tolerance and return objectives.”

China is a very large elephant in the room in any discussion of emerging markets. AXA Framlington Asia head of equities, Mark Tinker, compared China’s finances to a huge reservoir, with $70 trillion in household assets such as cash and housing. This reservoir is being built up by a savings rate of 50%, which adds $4 trillion a year to it. Tinker said that financial reforms are needed: “China needs a social security system, but also a private savings infrastructure, asset-backed securities, collateralised loan markets, municipal bonds, government bonds, index-linked securities, corporate bonds, deep and liquid equity markets – the whole western infrastructure.” As a result, Tinker said, these changes will create opportunities for some.

“Quick, agile and sophisticated financial companies will benefit from building the new infrastructure, while those dependent on traditional loans and property-related business will struggle. Indeed, it is difficult to see how property can avoid a hit more generally if liquidity is allowed to go anywhere else.” Social reforms are also changing China’s investment potential. Duncan Lawrie Private Bank investment analyst, Dean Cook, said: “The long-held misconception is that exports are the underlying force behind the Chinese economy. However net exports are actually only a small percentage of China’s GDP, sometimes as little as 5%. For most investors, the real opportunities lie in its consumer purchasing power.” Cook said that the Chinese government tackling important social reform would help China reach its full potential. “The one-child policy was introduced in the 1970s to bring down the rapidly-growing population. With suggestions that the Chinese population will peak in the next 15 years before then steadily declining, the announcement that this policy is to be curtailed is a positive initial step for the country,” Cook said.

According to the most recent National Association of Pension Funds (NAPF) survey, the average Local Government Pension Scheme allocation to emerging market equities in 2013 was 4%, up from 3.7% in 2012 and 3.4% in 2011. It should be noted that equity allocations generally fell over this period; UK equity allocations dropped from 26.6% in 2011 to 18.7% in 2013, for instance. In keeping with the overall approach to emerging market equities, Geoff Reader, who is head of pensions and treasury management at the Bedfordshire County Council Pension Fund, commented: “Just over a year ago the fund slightly changed its passive weightings to include a small direct allocation to EM in order to improve its overall weighting to that region.” Other funds have higher allocations to emerging markets than the average of 4% in 2013. For example, West Midlands Pension Fund recently increased its exposure to emerging market equities to 8.5% of its total assets, in line with its target asset allocation for the area. It said its emerging market debt allocation stayed constant at 3%.

Commenting on the increase its emerging market equities, West Midlands’ Geik Drever said: “The rationale for the increased allocation to emerging markets equities is strategic, reflecting our belief in the long-term growth potential of this area. A perennial issue for those interested in harnessing the economic fortunes of the emerging markets is whether this is best done by direct investing, or through Western corporates with strong links to emerging markets, or even through commodities, currencies or assets such as infrastructure. Here, Drever is unequivocal: “We believe that the best way for a long-term investor to play the emerging markets growth story is through direct investment in emerging markets equities.” And in terms of which regions or countries look attractive, Drever said: “We think that it makes sense to be well diversified – by company, country, region and sector – when it comes to investing in emerging markets.

Looking ahead, while emerging markets may face a rocky ride in the future, long-term investors feel they need exposure. In most cases, investing across the full range of emerging and frontier markets will help investors to find growth and diversification. PAAMCO’s Alper Ince said that stock-picking could be a good strategy. “There is now mis-pricing of individual securities, which emerging market long-short managers can take advantage of, as some good quality names are being included in the sell-off.” Ince added that he looked for domestic stocks which benefit from long-term trends, such as education providers in Brazil, which stand to gain from government financing, long-term demographic trends and consolidation in a fragmented sector. Elsewhere, Ince said: “I am also looking at Eastern European discount airlines. Pegasus Airlines in Turkey is picking up market share and is a well-managed company. The construction of a third airport at Istanbul is going to help them.”

While global macro-economic trends can disrupt emerging markets, experts like Ince also warn that political instability is something investors should watch for. For example, the Middle East is a tricky region for investors, with the ongoing effects of the Arab Spring and civil war in Syria as concerns, but an agreement with Iran is a positive. Against this, the greater use of shale gas in the USA means emerging market oil producers could be hit economically. With these provisos in mind, investors looking for long-term growth cannot afford to avoid the emerging markets. But finding the right formula to invest across a range of markets, each with its own characteristics, will continue to be a challenging task for investors in the years ahead.