Passive investment in emerging markets is gaining ground as more big pension funds look to invest but find active management wanting.
Overall, active emerging markets management remains the strategy of choice. But interest in passive strategies has begun increasing. The $62 billion California State Teachers' Retirement System, Sacramento, for example, will passively invest its forthcoming dedicated emerging markets allocation; fund officials wouldn't reveal the size.
And although the $16.9 billion New York City Teachers' Retirement System, the $9.7 billion New York City Teachers' Variable Fund and the $10.9 billion New York City Police Pension Fund all hired active emerging markets managers this year, not all of the target allocation have been distributed. The funds "are going to look seriously at passive products" when additional allocations go out, perhaps in 12 to 18 months, said New York Deputy Comptroller Jon Lukomnik, who represents the New York Comptroller on boards of the New York City public pension funds.
Moreover, the $3.1 billion Missouri State Employees' Retirement System, Jefferson City, will consider four passive managers among its 16 emerging market manager candidates. The fund expects to pick one manager for a $75 million portfolio, probably in June, said Chief Investment Officer Rick Dahl.
Experts say that for very large funds, passive investing in emerging markets may make sense in light of the relatively large allocations they would make; given the size of these investments, funds might otherwise be forced to hire an array of active managers, whose fees are noticeably higher than those of passive managers.
What's more, the performance of active emerging markets managers overall hasn't been stellar. Even as the entire sector wallowed in 1994 and 1995 (but not in this year's first quarter), the typical active manager worsened the problem by underperforming the much-watched Morgan Stanley Capital International Emerging Markets Free Index.
In fact, that problem persisted over the three years ended Dec. 31, 1995: the median manager in the emerging markets universe of InterSec Research Corp. underperformed the MSCI-EMF index in each of those three years, and has not outperformed the index since 1992. In the four years ended Dec. 31, 1995, the median manager's per annum 14.5% return just slightly nosed out the EMF index's 14.4%.
Such data made impressions on California teachers' fund officials.
"We started investing in emerging markets three years ago" by giving active international managers with emerging markets capability leeway to invest up to 20% in developing markets, said Thomas E. Flanigan, chief investment officer. The fund now has about $350 million in emerging markets. But when the fund wanted a specific emerging markets allocation, it took the passive route. Not only was size of allocation an issue, but so was performance.
Passive investment "became evident as the staff called my attention to the fact that emerging markets indexes were outperforming active management," said Mr. Flanigan. "We had thought active management had an edge because managers would be more knowledgeable in these areas and could be more fleet-of-foot" in addressing opportunities. "But this may not be the case," he said.
The fund is developing its own emerging markets index in conjunction with State Street Global Advisors, Boston. Although it hasn't been decided, the index may be equal-country weighted (with first and second tiers of 10 countries) vs. market-capitalization weighted, Mr. Flanigan said.
The New York City funds "chose active managers because we did not believe that existing passively managed products had yet been proven," said Mr. Lukomnik. "That being said, both funds reserved a large tranche" of future funding for emerging markets. "One of the key things we would be looking for would be a passive product.
"New York City historically has been a big believer in passively managed portfolios," Mr. Lukomnik said. But because emerging markets indexes have been changing - especially with the addition of South Africa's market into major indexes last year - it appeared they could still use a "little more seasoning," he said.
Of course, active managers believe they can outperform the indexes and, in some cases, they have. Data from Pensions & Investments' Performance Evaluation Reports show that for the three years ended Dec. 31, 1995, 10 of 21 managers for whom performance data were available bettered the 15.4% annualized return of the EMF index.
In order of performance, the managers were: City of London Investment Management Co. Ltd., London; Templeton Investment Counsel, Fort Lauderdale, Fla.; J.P.Morgan Investment Management, New York; Marvin & Palmer Associates, Wilmington, Del., and Pictet International Management, London, whose performances were tied; RogersCasey Investment Advisors, Darien, Conn.; Boston International Advisors, Boston; Lazard Freres Asset Management, New York; Genesis Investment Management, London; and AIG Asset Management, New York.
But whatever the pros and cons of active vs. passive emerging markets investing, ever larger sums in aggregate are flowing into the sector - despite poor 1994 and 1995 showings.
In the first quarter of 1996, pension funds hired managers for $772 million of emerging markets assignments. That was up from $670 million in 1995's first quarter and $146 million in the first quarter of 1994, according to data of Eager & Associates, Louisville, Ky. However, the number of placements fell to 26 in the first quarter vs. 29 in the same period last year, Eager's data show.
And these statistics only reflect known hirings. According to Reza Vishkai, international research director of consultant RogersCasey, Darien, Conn., emerging markets investing by his firm's clients was higher in the first quarter than in the previous 18 months.
Meanwhile, some funds are closed, including the $7.1 billion Emerging Markets Growth Fund of Los Angeles-based Capital International. As of mid-March, commitments for all 18.9 million of the fund's shares authorized for sale this year were taken up. It was the earliest share sellout since 1993 - the year that a limit on annual share sales was imposed, said company officials.