Emerging markets in Asia good in long run

NEW YORK — Institutional investors should make a strategic overweight to Asia's emerging markets to benefit from the region's long-term productivity gains, according to a new white paper by JPMorgan Asset Management officials.

Investors should increase their exposure to Asia ex-Japan over the long term to as much as double the market cap of the region, Rumi Masih, managing director and global head of strategic investment advisory group at JPMorgan, New York, and a co-author of the white paper, said in an interview.

Speaking hypothetically, he said if a fund had a portfolio invested 100% in global equities, the Asia ex-Japan weighting would be 10.5%.

An institutional investor can gain exposure through public equities, private equity or infrastructure. The increase would be funded from other developed markets, said Mr. Masih.

But others say this position will be a tough sell to U.S. institutional investors, who tend to shy away from making regional strategic bets.

Fred Dopfel, managing director and head of the client advisory group at Barclays Global Investors, San Francisco, said the idea makes sense, “but there is a significant risk of underperforming ... in the short and intermediate term.”

JPMorgan officials' argument in favor of a strategic investment in Asian emerging markets lies with the region's increase in productivity levels. Asian governments have made investments in infrastructure, technology and research and development to promote a more productive work force, which ultimately will lead to higher price-to-earnings ratios and higher long-term equity valuations for Asian stocks, said Mr. Masih.

China, for example, plans to increase the amount it spends on research and development by 21% per year over the next three years, increasing R&D spending to 2.1% of gross domestic product by 2010 from 1.5% of GDP last year, according to the report.

Between 1996 and 2006, China's productivity has increased an average of more than 7% per year; India's, about 4.5%. By contrast, productivity levels in the U.S. increased about 1.9% per year.

What JPMorgan executives see in Asia is a “virtuous cycle” of increased productivity levels leading to still further expectations of higher productivity, leading to more robust stock markets, Mr. Masih said.

JPMorgan officials expect that a $1 billion pension fund with 10% invested in Asian equities as of March 31 would generate 10-year compound annual returns of 5.5% with a volatility of 9.4% per year.

A $1 billion portfolio with that 10% allocated to domestic and developed equity can expect returns of 5.2% with volatility of 8.9%. A 10% allocation represents a four percentage point overweight to Asia ex-Japan.

That view challenges the traditional notion of investing in Asian emerging markets as a tactical growth play driven by gains in GDP.

“This is quite a new idea,” said Gustavo Galindo, a New York-based senior research analyst in the emerging markets equity research team for Russell Investments, Tacoma, Wash., about overweighting Asia ex-Japan on the merits of productivity levels.

Emerging markets managers generally look at productivity levels tangentially when deciding to overweight the region, Mr. Galindo said. Productivity is generally viewed as a lagging indicator of growth in GDP, he said.

Meanwhile, JPMorgan officials found evidence that GDP is not a reliable indicator of equity returns. They found a correlation of -0.37 between GDP and compounded real equity returns for 16 countries between 1900 and 2002. “That tells us that the conventional wisdom that you should invest in countries that are growing the quickest is faulty,” Mr. Masih said.

Consultants and strategists were hard pressed to name institutional investors in the U.S. making long-term strategic bets on Asia across their equity portfolios.

“Most U.S. investors simply make the split between the U.S. and everywhere else,” said Jay Kloepfer, director of capital market and alternatives research at Callan Associates Inc., San Francisco. Ultimately, the decision to overweight Asia will fall on the managers, he said.

Many pension executives still remember the sting from the run-up in the Japanese stock market in the 1980s when regional allocations were in vogue, he said. “The Japanese market went crazy — it became 60% of the (Morgan Stanley Capital International Europe, Australasia and Far East index),” said Mr. Kloepfer. “If you didn't have a huge Asia weight, you couldn't beat the index,” he said.

Reaching the 20% watermark that Mr. Masih suggests should be fairly easy for most investors, said Mark Ruloff, director of asset allocation at Watson Wyatt Worldwide Inc. in Arlington, Va.

But whether the exposure comes from public or private equity markets depends on the country, said Grant Fleming, managing director in the Tokyo office of Wilshire Private Markets, the private equity funds of funds group of Wilshire Associates Inc., Santa Monica, Calif. “In some countries, the private equity markets are not properly formed,” he said.

Contact Raquel Pichardo at [email protected]