Just when pension funds across the globe were getting comfortable with the idea of investing in emerging markets, their faith is being tested by disappointing performance.
The question is where performance in emerging markets — and institutional investments — go from here. Experts have different answers.
The long-term case for emerging markets is clear in the numbers: Over the 10 years through Nov. 30 the MSCI Emerging Markets index delivered an annualized 12.5% against 8.1% from the MSCI World index. Similarly, emerging markets debt has outperformed: The J.P. Morgan EMBI Global Total Return index returned an annualized 8.5% for 10 years through November, against 4.7% from the Barclays Capital U.S. Aggregate Bond index.
But more recently a combination of the previous uncertainty over when U.S. tapering of quantitative easing would begin — which led to sell-offs in early summer — a stronger U.S. dollar and muted economic growth relative to previous years have pushed emerging markets returns down in both equities and bonds. The uncertainty is muddying the waters when it comes to decision-making on keeping existing or putting new money into these investments. On the fixed-income side, the J.P. Morgan EMBI Global Total Return index underperformed developed markets, with -6.5% year to date through Dec. 19 vs. -1.9% for the Barclays Aggregate Bond index. But the MSCI EMI returned -3.6% this year through Dec. 19, significantly underperforming a 24.2% return in developed markets.
According to a 2014 outlook paper published by eVestment LLC, an institutional investment data and analytics provider, emerging markets equity strategies reported net outflows of $1.8 billion in the third quarter — the first time there have been net outflows since the fourth quarter of 2007. Yet emerging markets all-cap equity was the most-searched universe at eVestment through the first three quarters of this year, in terms of average monthly views and total monthly views.
“Emerging markets have seen a lot of volatility over the last year, and that has an impact on (investor) sentiment,” said Deb Clarke, London-based global head of investment research at consultant Mercer.
It is not just institutional investor sentiment that has been hit — experts, too, appear to be split on these asset classes, given low returns and valuations.
Money manager Schroders PLC is broadly cautious on the outlook for emerging markets.
“The domestic environment for most emerging market bonds remains challenging due to slow growth and rising inflation, posing a challenge to central banks,” said Matthias Scheiber, London-based fund manager, multiasset investment, at Schroders. The money manager has upgraded its view on emerging markets currencies, but is negative emerging markets bonds and “rather neutral on emerging markets equities,” according to Mr. Scheiber.
Schroders is avoiding U.S. dollar-denominated bonds due to an expectation of higher long-term U.S. interest rates and the additional carry for emerging bonds not able to offset higher rates. The manager is neutral on emerging markets equities as “valuation is not compelling despite the recent underperformance,” Mr. Scheiber said.
Despite the slowdown in emerging markets, experts say institutional investors have not completely abandoned their belief in the long-term opportunities. The eVestment all emerging markets fixed-income universe is expected to gain more than $50 billion in net inflows through next year, while emerging markets all-cap equity strategies are forecast to bring inflows of more than $20 billion in 2014.
According to the latest figures from eVestment, institutional emerging markets debt assets under management dropped 15% between June and September, from $473 billion to $404 billion, and was down 9% compared with $442 billion in September 2012. The drops followed strong inflows over the two years through September 2013, when assets were up 38% from $293 billion in September 2011.
Rob Drijkoningen, managing director and co-head of emerging markets debt at Neuberger Berman, based in The Hague, Netherlands, said while inflows have not been as buoyant as they had been over the past five years, “we see anecdotal evidence in RFPs that institutional investors continue to expand (emerging markets exposure) — the theme is diversification and outside of (U.S. dollar-denominated and into local currency investments). Even though emerging markets are decelerating, that does not seem to change that picture. It is a question of time (when it comes to) growth increasing again in emerging markets — for every one percentage point growth increase in developed markets, emerging markets growth increases by 0.6%.”
Mr. Drijkoningen said behavior has changed among these investors, however, with clients “at the margins” asking the money manager to pick out 10 or so countries for emerging markets exposure, rather than taking a broader approach. “But there are serious question marks over that approach. We would maybe avoid a country like Greece, while Argentina and Venezuela are tough — but if they improved policies, then we wouldn't want to exclude them and miss opportunities.”
Nick Gartside, London-based managing director, international chief investment officer of fixed income at J.P. Morgan Asset Management (JPM), told a different story when it comes to emerging markets debt and investor behavior. He said the $1.5 trillion money manager has seen cash outflows from emerging markets.
“People are ... selling emerging markets debt,” Mr. Gartside said. “But there is a point where some of those valuations do become irresistible. We don't think it is so simple to avoid or buy it — there will be a time to buy it; we just don't think it is that time.”
On the equities side, however, J.P. Morgan Asset Management's experience is different. Richard Titherington, London-based CIO for emerging market equities, said institutional clients are focusing on allocating to global emerging markets over a regional approach.
Regarding this split in manager consensus, Mercer's Ms. Clarke said: “We believe much of the recent turbulence has been caused by a focus on short-term factors rather than the long-term drivers of growth and potential for investment returns. We recognize that many of the areas that investors are seeking exposure to, namely the domestic emerging consumer, are trading at high valuations, which is making it challenging for some managers to find ideas at present. However, we believe there is enough depth and breadth in the investment universe for managers to identify opportunities.”
While long-term investment remains Mercer's stance on both emerging markets equities and debt, she added, “there may be good entry levels at times, based on short-term volatility.”
This article originally appeared in the December 23, 2013 print issue as, "Low emerging markets returns have investors wary".