Incorporating emerging markets into your investment strategy

Written By: Matthew Craig LAPF Investments

In the wake of recent underperformance in emerging markets, Matthew Craig examines how local authorities are planning to maximise the potential of the sector

For investors such as local authority pension funds, the emerging markets now offer a wide range of investment opportunities, even if they are often crammed into one or two allocations within a portfolio.

In terms of asset allocation decisions, emerging market equities can be kept within an overall global equities allocation, or in a dedicated emerging markets brief. And developed market companies may frequently benefit from growth in the emerging markets, meaning they also give some emerging market exposure. Emerging market debt can also be part of an overall fixed income holding, or held separately. In addition, for both emerging bonds and equities, investors can choose a passive fund, tracking an index, or invest more actively, increasing the options open to them. As well as taking the bond or equity route, investors can now seek to benefit from the growth of emerging markets through alternative assets, such as hedge funds, commodities, private equity or infrastructure.

At present, local authority pension funds have a combined equity allocation of around 60% of assets – according to evidence given in the recent LGPS consultation on greater use of passive investment. This is ahead of the UK pension fund exposure to equities, which is around 46%, meaning local authority funds are likely to have an above-average weighting to emerging market equities. Geoff Reader, head of pensions at Bedfordshire Pension Fund, said the fund had a direct allocation to emerging market equities of 2% through global mandates. Reader commented on the allocation: “This is a diversification of our passive equities.” Direct emerging market equity allocations of this order are often the case at local authority funds. For instance, the latest report from the Strathclyde Pension Fund shows that while it has an overall equity allocation of 72.5%, it has a specialist emerging market allocation of 2.4% of assets. It too has a large passive allocation, showing that direct emerging market equity allocations may have to compete with a passive global equities allocation for a larger slice of the pie. It should also be borne in mind that emerging markets make up around 12% of global market capitalisation, so many investors are underweight for direct allocations.

When looking at the case for a larger direct allocation to emerging markets, investors face a number of competing issues. In the developed economies, growth has slowed since the financial crisis, making emerging markets look a better bet for higher growth rates. But against this, there is no shortage of possibly adverse geopolitical or economic news, such as unrest in the Middle East, the conflict in the Ukraine and the prospect of higher interest rates squeezing liquidity in emerging markets, as shown by the mid-2013 “taper tantrum” when emerging market performance dipped after the Federal Reserve announced plans to taper QE, reducing liquidity. Commenting on geopolitical risk and emerging markets, Ashmore head of research, Jan Dehn, said: “Why does geopolitical risk initially spark so much asset price volatility? One reason is that geopolitical events are unambiguously more complex.” Dehn added that a statistical formula shows that the complexity increases as more countries are involved in geopolitical events, and that markets can struggle to cope with additional complexity. In this case, investors and managers should seek to analyse the cause of geopolitical risk, as they would with other risk factors. Dehn concluded: “Geopolitical risk is part and parcel of human reality. Hence, it is part and parcel of manager risk in any country, at any time.” While this is undeniably true, for most pension funds the decision of how much geopolitical risk to take is a difficult one and it explains, in part, the relatively low direct allocations to emerging market equities. Normally, a manager appointed to an emerging market equities brief will have the freedom to allocate across a range of markets, enabling them to avoid trouble-spots such as the Ukraine and Russia at present.

If emerging market equities have a low direct allocation, then the direct investments in emerging market debt are likely to be even lower. In many cases, emerging market debt will be part of a wider fixed income allocation. Given the recent very low yields on developed market government bonds and corporate debt though, the case for emerging market debt is growing stronger. AXA Investment Managers head of emerging markets, fixed income, Damien Buchet, commented: “The spread offered for EM credits over the US or Eurozone presents significant spread premia of 60-100% at each rating level (AAA through to BBB, BB, B and so on). In the short duration market, investors are receiving more reward for credit risk but for generally lower duration, so there is potentially less market risk.”

As an example of the performance of emerging market debt, Brazilian corporate credit has produced a 9.2% total return to date in 2014, compared to 6.1% for emerging market debt overall and 4.8% for developed market high yield debt, according to Hermes Investment Management senior credit analyst, Jon Brager. Brager said that this outperformance was down to valuations, rather than the strength of the Brazilian economy or a positive outlook for it. “Put simply, the market priced in a credit environment for EM debt that was far worse than what actually unfolded. Also, the rally in US Treasuries has helped improve sentiments towards emerging markets and likely aided in stabilising fund flows.”

Looking at emerging markets as a whole, it is clear that their pre-crisis economic model of relying on exports, through cheap labour and strong demand from developed markets, has ended. Emerging market countries, like those in the developed markets, have had to repair balance sheets and move towards more rounded economic models. Hermes head of emerging markets, Gary Greenberg, commented: “The old explosive export-driven growth that was the hallmark of EM economies was marked by acute market volatility. This boom-bust cycle has curbed enthusiasm for breakneck expansion with EM policymakers. Hence, a number of EMs have made the decision to embark on a path of supply side reforms, potentially underwriting a path of sustainable, long-term, steady growth.” As a result, investors are now showing a preference for emerging market countries which are reforming, such as Mexico, Columbia, Korea, Malaysia or Philippines. At the same time, countries which are seen as weaker in terms of reform, or for other reasons, such as Russia or Turkey, are less attractive. Greenberg put it like this: “Emerging market economies are at the crossroads. But there are signposts to growth, if you can decipher them. The old export-driven model is dead. A new one is being born, where capital discipline is king. The story for emerging markets is improving, and changing from one of trading to one of long-term investment.”

A major talking point for emerging market investors at any time, but especially now, is China. On one hand, there is a concern that China’s growth rate is slowing, but against this, it can be a hard market to read. Hermes’ Greenberg said: “It is difficult to see, let alone forecast, what is really going on in the Chinese economy. Property prices and construction are falling, as is electricity production. Typhoons in June are being blamed by many companies for poor results, and earnings estimates for many consumer staples companies are being trimmed.” At the same time, AXA Investment Managers emerging Asia economist, Aidan Yao, said that a mix of seasonal, cyclical and structural factors are affecting China. He commented: “We expect growth to be weaker in the second half of the year, as policymakers focus on structural reforms. Although Beijing appears more tolerant towards slower growth, we think decisive action will be taken to defend the official growth bottom line.” While China’s economy may be changing direction and this could hold back equity investors, Ashmore’s Dehn sees it differently from a debt perspective: “We think China’s onshore government bond market in particular is one of the most interesting bond markets in the world today.”

For investors, emerging markets are an important part of the investment jigsaw, but putting the pieces together could be a puzzle. Emerging markets offer diversification and good returns, but the performance of different countries can vary widely. Some investors may decide to continue with small dedicated portfolios to emerging markets, knowing that they have indirect exposure to emerging markets elsewhere in their portfolios. For example, an absolute return bond mandate could include emerging market debt, or a high-conviction equity fund could hold some emerging market equity stocks a manager likes. In this way, emerging market assets could become more important to investors over time.