Just as institutional investors are viewing emerging markets as a mainstream, must-have part of an investment portfolio, the chairman and CEO of the world's largest money manager thinks the term will soon cease to be relevant.
“We talk about emerging markets as if they are one compatible, cohesive market — but within emerging markets we have some very good examples of well-run countries, and we have some real garbage,” said Laurence D. Fink, chairman and CEO of BlackRock (BLK) Inc. (BLK), New York, which has $4.3 trillion under management.
“When China was growing at 10% to 12% a year, it hid the garbage,” said Mr. Fink, speaking March 7 at the National Association of Pension Funds investment conference in Edinburgh. “I do believe the future of investing in emerging markets is going to change and very rapidly. ... I do believe we will see much more granularity in the investment of the developing world and we will stop talking about emerging markets as an asset class.” He cited the way investors take a granular approach to U.K. investment, focusing separately from the rest of Europe, as an example.
Mr. Fink's comments were supported by delegates at the conference. One money management executive, who asked not to be named, said he agreed with Mr. Fink's view that emerging markets countries should and probably will be considered in smaller groupings or even individually, “which makes sense if you look at what happened last year and in the first few weeks of this year.”
The executive was referring to the performance of the MSCI Emerging Markets index, which returned -2.4% in U.S. dollar terms for 2013, compared with an 18.6% gain the year before. That compared with the MSCI World index, which gained 27.4% in 2013, up from 16.5% in 2012. That trend has continued into this year, with returns for the emerging markets index in the year through March 11 at -4.52% in dollar terms.
Add to that political concerns regarding Russia and Ukraine, plus continued political unrest in Turkey and Thailand, and you have a cocktail that is sure to leave some investors nervous about broad emerging markets exposure.
Countries to avoid
“(Investors) may want to avoid Turkey, Indonesia, India and Brazil,” said Marcus Svedberg, Geneva-based chief economist at East Capital International AB. “That is not easily done. Most Eastern European funds have a huge (exposure) to Russia. Likewise, it is very hard to invest in Asia without (exposure to) China and Hong Kong.
“The problem is that the goal post is changing. Turkey is a perfect example — it was the investor darling up until mid-May 2013. Investors could not get enough of it. But economic problems, tapering (in the U.S.) and political problems moved it from the darling to the dog.” East Capital runs about $4.5 billion of assets, with almost half dedicated to Russia, Mr. Svedberg said.
Some investors still employ a general allocation. “We use managers who cover the space broadly, not by individual countries or regions,” said Girard Miller, chief investment officer at the $11 billion Orange County Employees Retirement System, Santa Ana, Calif., in an e-mail. “We leave to them the country selection/weighting process.”
Pension fund managers in the U.K., however, seem to be more involved.
“Going forward, emerging markets for us means as much the digital environment rather than just the physical one,” said Antony Barker, Manchester, England-based director of pensions at Santander UK PLC. “The geographical heterogeneity irrelevance argument rarely troubles investors. Twenty years ago, equity managers were appointed on Pacific including- and ex-Japan mandates, and a debate raged as to which was best — which was just as illogical as Japan is closer to the U.K. than it is to New Zealand and Australia.”
Mr. Barker said the conversation over global small-cap companies is also a problem, since a U.S. small-cap company could have a capitalization that is big enough to be defined as large cap elsewhere. “Ultimately, you are looking for the investible opportunities that best capture economic growth and profits, however and wherever defined,” he said.
Money managers agree.
“We have heard similar lines from asset managers asking whether emerging markets continues to exist as an asset class,” said Iain Douglas, investment consultant, head of Asia ex-Japan equity manager research and part of the global manager research team at Towers Watson & Co. in New York.
One of the problems, Mr. Douglas said, is that exposures are blurred with companies within global indexes having more exposure to emerging markets, and vice versa.
The original coining of the term, in 1981, carried with it a “straightforward definition that was universally applicable,” said Kweku Obed, Chicago-based senior vice president at Marquette Associates Inc., in a March research paper on emerging markets. “Today, emerging markets is more loosely defined, as countries that fall into the emerging category can vary drastically in size, GDP and economic stature,” he wrote.
Mr. Obed said the grayness of the term now means investors need to reconsider whether a broad allocation is suitable for them, or whether they need to diversify across benchmarks, market capitalizations or frontier markets “which are at least worth a serious discussion,” he said in e-mailed comment.
The answer, say managers and consultants, is to employ more active management in investment — something Mr. Fink referred to in his presentation at the conference and something money management executives say is becoming commonplace in emerging markets allocations.
“People shouldn't be putting artificial constraints on where they invest, but should be looking very broadly and diversifying as much as they can,” said John Stainsby, London-based managing director and head of U.K. institutional business at J.P. Morgan Asset Management (JPM). “We have large, sophisticated investors looking to invest in Brazilian real estate or African investments or quite specialized areas. This is normally because they have had a good experience in those areas that they want to keep going.”
Emerging markets investment is also a question of whether these investors are being sufficiently compensated for the additional risk the more volatile markets, like emerging markets, present.
“People continue to think of emerging markets as something of a monolith,” said Bryon Willy, Chicago-based principal at Mercer LLC. “But I also think that investors have a penchant for active management, due to obvious diversity across the opportunity set. There is a case for active management in emerging markets; there are emerging markets that we probably don't want to have any part of — Venezuela and Russia for political reasons, Greece for financial reasons.”
However, Mr. Willy said there is also still a “very compelling” case for investing in general in emerging markets, because of long-term growth prospects and higher real yields. “There is a question around whether investors are getting rewarded for the risk they are taking because of the headwinds. There is no compelling reason to do it passively,” he said.
There is also opportunity on the beta side. “In addition to gaining cheap broad market exposure through passive or smart beta, clients can invest in high conviction, differentiated regional strategies or have a broad investment into more niche areas — more exposure to emerging markets consumer, for example,” Mr. Douglas said. He said the consultant continues to see issues with broad active emerging markets managers, some of which are managing “too close to the index for the fees they are charging.”
Forget about countries
But Peter Marber, Boston-based head of emerging markets at Loomis Sayles & Co. LP, thinks investors should forget about countries altogether, especially when it comes to investing in emerging markets debt.
“The best way to stack up emerging markets debt is not index to index, but ratings segment by ratings segment,” Mr. Marber said in a session at the NAPF conference. “I don't even want you to think about countries as opposed to looking at ratings sectors. Compare these to other liquid, tradable bonds that you would have in your portfolio. Not all companies or countries are created equal — find good managers that put you in good situations,” he said.
In a further conversation, Mr. Marber said: “People often lump together emerging markets countries with different sized populations, productivity levels, consumption and export compositions et cetera. But not all emerging markets are created equal.”
This article originally appeared in the March 17, 2014 print issue as, "Investors are shifting their approach to emerging markets".