Emerging market debt and equity, once considered a walk on the wild side, are fast becoming a popular choice for investors who place a high value on sleeping well at night.
The “wild” image emerging markets once had is out of date, and a growing number of investors are concluding that “you can’t not be there,” said James Upton, a senior portfolio specialist and chief administrative officer for the emerging markets equity team at New York-based Morgan Stanley Investment Management.
For the four years ended Dec. 31, being there has been a rewarding choice: The Morgan Stanley Capital International Emerging Markets index has delivered an annualized gain of 36.4% a year in dollar terms, helped by heavy net inflows from institutional and retail investors alike.
According to the Washington-based Institute of International Finance Inc., net global flows into emerging markets equities in 2006 came to a record $70 billion, up from $56 billion in 2005 and $39 billion in 2004. Meanwhile, data from Darien, Conn.-based Casey Quirk & Associates showed U.S. institutional investor allocations of $229.7 billion to emerging markets equities at the end of 2006, with net inflows of $7.1 billion for the year. U.S. retail investors, meanwhile, put a combined $28 billion into emerging markets mutual funds equities in 2005 and 2006, according to data from the Washington-based Investment Company Institute.
For 2007, the IIF predicts flows into emerging markets equities will ease a bit to $63.5 billion, mostly due to a falloff in hefty initial public offerings in China.
Emerging markets debt, while less established than emerging markets equity, is likewise attracting a growing number of yield-hungry investors.
Money managers have responded with a flurry of new dedicated strategies. On April 16, Acadian Asset Management Inc. announced a new emerging market debt capability, only six months after the Boston-based firm launched a “frontier” strategy to invest in markets such as Botswana and Slovenia.
Also on April 16, Aberdeen Asset Management Inc., Philadelphia, launched its first mutual fund aimed at U.S. institutional investors, the Aberdeen Emerging Markets fund, two weeks after the firm’s Scotland-based parent, Aberdeen Asset Management PLC, launched a small-cap emerging markets equity strategy.
On March 30, Los Angeles-based Causeway Capital Management LLC announced a new quantitative emerging markets equity fund. Meanwhile, over the past year, a number of fixed income managers, including Pacific Investment Manage- ment Co., Western Asset Management Co., JPMorgan Asset Management and INVESCO, have brought out local-currency emerging market debt strategies.
This isn’t the first time in their roller-coaster history that emerging markets have been hot, and investors old enough to look back a decade will remember that past joy rides have ended in tears.
Those episodes — including Mexico’s “tequila crisis” of 1995, the “Asian contagion” of 1997 and Russia’s debt crisis of 1998 — resulted in part from domestic economic vulnerabilities.
For example, the backdrop to the Asian crisis was heavy dollar borrowing by countries and companies in the region that took advantage of pegged currencies to tap lower lending rates overseas, at times to finance dubious projects. The capital flight that followed Thailand’s July 1997 announcement that its dwindling currency reserves could no longer sustain the baht’s peg to the dollar swept away most of the region’s fixed exchange-rate regimes, crushing local stock and bond markets as the cost of servicing that dollar debt soared.
More stable markets
This time around, market watchers said they’re confident emerging markets won’t self-destruct, as countries and companies in the sector have become more disciplined. Helped by booming demand for commodities, current account deficits have mostly given way to surpluses, and foreign currency reserves have surged. Meanwhile, corporate debt-to-equity ratios have tumbled from more than 80% a decade ago to around 20% today, and companies have become far more transparent and focused, portfolio managers say.
Emerging markets are “in better shape than they’ve ever been,” said Jeffrey Urbina, a principal with Chicago-based William Blair & Co. and a portfolio manager of the firm’s $4.7 billion international growth emerging markets equity strategy. “From an investor’s standpoint, these markets are less susceptible to boom and bust than they were before.”
That progress shouldn’t be written off as a temporary by-product of surging commodities prices, observers said. The commodities boom has helped emerging markets, but the real key is what those countries did with the opportunity, said Michael Gomez, portfolio manager of Newport Beach, Calif.-based PIMCO’s $2.5 billion PIMCO emerging markets bond fund.
Most countries seem to have passed the test. Normally, with emerging markets governments this far into an oil or commodity boom, “you would have seen tons of mistakes being made,” said Mike Conelius, an emerging markets debt portfolio manager with Baltimore-based T. Rowe Price Group Inc. Instead, this time around, countries are mostly doing the right things, including aggressively paying down debt and building up foreign currency reserves, he said.
Russia is a prime example, with that country’s reserves surging from less than $10 billion in 1999 to $315 billion today, while rebounding from chronic fiscal deficits in the late 1990s to strong surpluses in recent years.
Progress like that makes the prospect of “wholesale regional crises” extremely remote, said James Donald, managing director of New York-based Lazard Asset Management and head of the firm’s emerging markets group. “We’ll always have crises in emerging markets,” but the “dominos” of yester-year have become today’s isolated affairs, he said.
Analysts say the minor ripples that followed flare-ups during the past five or six years in countries such as Argentina, Indonesia, Thailand and Brazil support that contention.
The story at the corporate level has been encouraging as well. Companies such as Seoul-based Samsung Electronics Co., which in the past diverted resources from profitable segments to fund the company’s move into a sprawling range of businesses, have become more focused and profitable. Even after four years of strong gains, the price-earnings ratio for emerging markets equities remains at roughly a 20% discount to developed market equities, noted Hugh Young, managing director of Aberdeen Asset Management Singapore Ltd.
Lurking dangers
All that progress doesn’t mean emerging markets can’t get shellacked again, either by a falloff in global demand or a diminished appetite for risk.
While emerging markets remain attractive, the current stretch of low volatility will likely prove the exception rather than the rule, said Eric Winig, a research consultant with investment consultant Cambridge Associates LLC, Boston. It’s “not for the faint of heart,” and Cambridge tells clients “don’t get into it if you’re going to get scared out by a 15% to 20% decline,” he said.
The 8.8% plunge of China’s Shanghai Composite index on Feb. 27, which dragged down emerging and developing markets alike, was a timely reminder of that volatility. Days like that may prompt investors to reassess their apparent faith that this “goldilocks” global environment can roll on undisturbed, said Keith Savard, the principal author of the IFF report.
Even so, analysts say the next time sentiment sours, emerging market macro policies and corporate decisions are less likely to be the cause.
Valuations in some markets have become stretched, but any scenario that hits emerging markets across the board is more likely to result from external problems, such as the U.S. economy stumbling, said Mark Headley, chief executive officer of Matthews International Capital Management LLC, San Francisco.
“If China were to melt down, the Asian crisis would look like a tea party,” said Mark Madden, a portfolio manager of Boston-based OFI Institutional Asset Management’s $862 million Emerging Markets Equity strategy. Barring something out of left field, however, these economies should enjoy another two or three years of healthy domestic consumption growth before the cycle turns, he said.
The basic message is ‘yes, there’s incremental risk and more volatility,’ but investors today are more inclined to view the asset class as akin to small cap domestic equities in that regard, rather than as the “wild frontier,” said Scott Leiberton, managing director and equity product specialist, Principal Global Investors, Des Moines, Iowa.
Buy-and-hold changes
Growing interest from buy-and-hold institutional investors should also lower volatility. Ten years ago, only a handful of portfolio managers were looking at an emerging market debt sector dominated by investment banks and hedge funds, said John H. Carlson, whose $2.3 billion Fidelity New Markets Income fund was the first U.S. mutual fund to invest in emerging markets debt when it launched in 1993. Today, long-term investors such as pension funds and endowments, together with local funds being set up in the emerging markets themselves, dominate, he said.
“It’s gone from a mostly hedge fund, fast money, ‘wild-west’ environment, to a dedicated, long-term, fundamental environment,” agreed Gunther Heiland, co-head of emerging market debt with JPMorgan Asset Management.
The emergence of big pension funds in the emerging markets, meanwhile, is providing a new anchor class of long-term investors. The rapid buildup of the middle class in emerging markets has led to “the building out of some pretty serious dedicated retirement systems, particularly in Latin America,” allowing countries to finance more of their needs domestically and issue longer-dated bonds, said Peter J. Wilby, the chief investment officer of New York-based Stone Harbor Investment Partners LLC.
Even hedge funds — famously blamed in 1997 by Mahathir Mohamad, then prime minister of Malaysia, for causing the “Asian contagion” — are no longer bogeymen, in part because their focus has changed as well. Virginia Reynolds Parker, CEO and CIO of Stamford, Conn.-based Parker Global Strategies, said the hedge fund story in emerging markets today has become “much, much more of an investment story than a trading and speculative type story.”
Hedge fund activity in emerging markets has shifted from global macro to “more fundamentally oriented strategies,” agreed Cynthia J. Nicoll, CIO of Rye, N.Y.-based hedge fund of funds provider Tremont Capital Management Inc. Six of the roughly 40 hedge funds in Tremont’s fund of funds strategy are pure emerging markets managers, with long-short equity, emerging market debt and event-driven strategies all well represented, she said.
Meanwhile, the tendency of long-term investors to rebalance their portfolios in order to stay within asset allocation targets is another factor that should lower volatility. Stan Mavromates, chief investment officer of the $46.7 billion Massachusetts Pension Reserves Investment Management Board, Boston, said PRIM trimmed nearly $500 million from its emerging markets equity holdings in 2006, and another $450 million so far in 2007, in order to maintain the system’s 5% target weighting.
According to data from Boston-based InterSec Research Corp., U.S. institutional investors trimmed $16.6 billion from their emerging market equity mandates through rebalancing in 2006, up from $16 billion in 2005 and $12.3 billion in 2004.
Index activity
Feverish activity recently on the part of index designers is another sign that emerging markets are becoming more institutional.
Devan Kaloo, Aberdeen’s London-based head of global emerging markets equities, said his firm’s small-cap emerging markets strategy is coming out just as Morgan Stanley Capital International is slated to bring out an MSCI emerging markets small-cap index in June.
Investors will increasingly look to target finer slices of the sector, and small caps should prove a superior way to play the long-term growth story there, he said.
Elsewhere, on March 5, AIG Financial Products Corp. launched the AIG Emerging Markets Foreign Exchange family of investible indexes,which allow investors to obtain passive exposure to emerging markets foreign exchange.
JPMorgan’s June 2005 launch of a series of local currency emerging markets bond indexes, meanwhile, has made it easier for money managers to market that dynamic asset class to institutional investors. Owi S. Ruivivar, a portfolio manager of Goldman Sachs Asset Management’s $1.6 billion emerging markets debt strategy, noted that 13 of 16 local currency emerging market debt strategies now offered in Europe were launched after the JPMorgan indexes came out.
Pension fund exposure
While most big pension funds already have emerging markets exposure, some investment consultants recommend allowing international or global managers to make opportunistic purchases there while other prefer dedicated mandates.
Ron Radcliff, a consultant with Watson Wyatt Worldwide in Arlington, Va., said a broader portfolio can make sense, especially with so many of the best dedicated strategies already closed to new investors. For an asset class that remains relatively volatile, playing in a bigger pond, such as international equities, can be an advantage, he said. For example, during a panicky sell-off, a pure emerging markets manager could face redemptions which force him to sell at the worst moment.
Frederick Schaefer, a senior consultant with Norwalk, Conn.-based Evaluation Associates LLC, said his firm prefers a dedicated exposure to emerging markets. Clients that get exposure opportunistically risk finding themselves holding the same big multinationals that just happen to be based in emerging markets, rather than smaller companies there that will benefit the most from domestic growth.
For dedicated allocations, Steve A. Schoenfeld, the CIO of global quantitative management with Chicago-based Northern Trust Global Investments, said investors should consider mixing passive and active strategies. The argument that relative inefficiencies make active management a no-brainer aren’t born out by market data, he said.
Local currency bonds
On the fixed-income side, only a smattering of big U.S. pension funds have dedicated emerging market debt allocations, with a far greater number getting exposure through core plus mandates. European investors have made more dedicated allocations, but portfolio managers say there are recent signs that interest is picking up among U.S. institutional investors as well.
Peter M. Gilbert, the CIO of the $32 billion Pennsylvania State Employees’ Retirement System, said his plan opted to make a dedicated allocation to emerging market debt in 2005, 10 years after it switched from an opportunistic to a dedicated exposure to emerging markets equity. Today, Pennsylvania has a mix of long-only managers and hedge funds overseeing $1.2 billion in dollar-denominated and local-currency debt – roughly 4% of its overall portfolio and 25% of its fixed income holdings.
Some analysts say the need for yield could prompt more U.S. investors to skip over dollar-denominated debt – where spreads over 10-year U.S. treasuries have dropped to historically lows of less than 170 basis points – and head for local currency bonds, where the bulk of issuance has been in recent years.
There’s been a tendency to wait for those tight spreads to widen out, but in recent years, the U.S. investor base has come to appreciate that the asset class has evolved into two pretty distinct strands, and that local currency debt is the one offering compelling valuations and diversification benefits, said GSAM’s Ms. Ruivivar. For the first time, U.S. investors appear to be getting enthusiastic, she said.
PIMCO’s Mr. Gomez said more and more clients are asking him to move from 100% external-currency bonds to some mix between external and local-currency bonds. In response to that trend, PIMCO launched a local currency bond mutual fund on Dec. 29, which has gathered $400 million during the first quarter of 2007.
Cynthia Steer, the head of fixed-income research with Darien, Conn.-based investment consultant RogersCasey, said the sharp growth of issuance in emerging market debt, and local currency debt in particular, should lift institutional allocations to that asset class from “relatively modest” levels of 1% to 2% to “well over 10% over the next five to 10 years.” She said RogersCasey has been advocating separate account exposure since 1999.
Not everyone agrees that local currency debt can meet a sharp pick-up in investor demand over the near-term. Paul Denoon — a portfolio manager who helps oversee New York-based AllianceBernstein LP’s $13.2 billion in emerging market debt, including $4.1 billion in local currency debt — said the size of the local currency market, at perhaps $600 billion today, will work against any surge in interest. In any case, “very few institutions, from what we’ve seen, would be willing to directly, in a separate account, have the type of derivative structures needed to invest there” today, he said.
