Preparing for the future

Money managers are adding more arrows to their emerging markets quiver as they anticipate institutional investor demand for such strategies to escalate over time.

“My sense is that there are adequate products for the interest you have today, but that will change in the midterm period (of about five years) in which you'll have enhanced demand,” said Paul Matson, executive director of the $23 billion Arizona State Retirement System, Phoenix. “Furthermore, as emerging markets improve their domestic infrastructures, there will be more opportunities from the supply side and as a result, more products available.”

Consultants expect more pension funds to allocate to dedicated emerging market strategies within the next five years.

“The magnitude of those allocations” will also increase, said Terry Dennison, worldwide partner and U.S. director of consulting at Mercer Investment Consulting based in Los Angeles. “Instead of the current 5% range, (institutional investors) will probably be looking at 10% to 15% of total assets. And it will be strategic rather than tactical.”

Other consultants and managers said that longer term, developing nations might account for as much as 35% or more of the entire portfolio.

Managers that have been dedicating more resources to emerging market teams and products to capture this potential include: Pacific Investment Management Co. LLC; J.P. Morgan Asset Management; T. Rowe Price Group Inc.; Goldman Sachs Asset Management; Aberdeen Asset Management LLC; and The Boston Co. Asset Management LLC.

Others, such as emerging market specialists Franklin Templeton Investments and Ashmore Investment Management Ltd., also are reaping the benefits of increased investor interest. The firms reported $12.2 billion and $3.6 billion in net asset inflows, respectively, for the quarter ended Sept. 30.

“Institutional investors are gradually increasing allocations to emerging markets or thinking about (adding exposure) as part of a broader portfolio restructuring,” said Mark Mobius, executive chairman of Franklin Templeton, San Mateo, Calif., which manages about $30 billion in dedicated active emerging market strategies.

Consultants said institutional investors are likely to access the returns potential of emerging markets growth through relatively liquid asset classes such as equities, fixed income and currency — the areas on which most managers are also likely to focus.

So far, pension fund executives have been putting bigger bets on the equity markets than emerging market fixed income, but consultants expect to see more demand for the latter in the next several years.

Craig Mercer, senior investment consultant within the global manager research team at Watson Wyatt Worldwide based in London, said the case for emerging market debt is based on long-term improvements in economic fundamentals in these countries, leading to higher credit quality, lower cost of borrowing and more liquidity. An exposure to local currency debt allows investors to benefit from any appreciation of emerging market currencies relative to G7 currencies, he said.

Some managers have been hiring to boost their emerging market fixed-income capabilities. For example, PIMCO went to 10 from eight portfolio managers globally since the second half of 2008. The firm introduced a dedicated emerging market product in 2008 targeting companies involved in infrastructure projects and plans to launch a separate Asian emerging market debt strategy next year.

Emerging markets also feature highly in PIMCO's Global Advantage Bond index, which is gross-domestic-product-weighted rather than being based on market capitalization and includes a broader set of fixed-income instruments. Emerging markets account for about 25% of GLADI compared with their single-digit weighting in the Barclays Capital Aggregate index, said Michael Gomez, executive vice president and co-head of the emerging markets portfolio management team based in Munich.

Market-cap weights are “backward looking” because they capture past economic trends and capital market developments, whereas GDP weights are more “forward looking,” Mr. Gomez added. Dedicated emerging market strategies account for $23 billion in assets under management. Another $40 billion in emerging market assets are invested within more generalist portfolios such as the firm's diversified income strategy.

Aberdeen Asset Management's emerging market team grew by two investment professionals - one in the emerging market debt team and the other in the global emerging market division - as a result of its acquisition of Credit Suisse Asset Management's U.K. business at the end of 2008.

Goldman Sachs AM is also planning to strengthen its operations in Brazil. Firmwide, the emerging market team has expanded to 25 investment professionals based in seven international offices compared with 11 professionals in two offices five years ago.

Elsewhere, J.P. Morgan AM added three investment professionals to its emerging markets team so far this year, including Pierre-Yves Bareau as head of emerging market debt. (Mr. Bareau was CIO of emerging market debt at Fortis Investments.) New products have not been launched in the U.S. in 2009, but firm officials are considering adding a small-cap to midcap emerging market equity strategy.

Tom Leventhorpe, vice president of global emerging markets at J.P. Morgan AM, New York, said assets under management at the firm have doubled since January, while emerging market assets have generally risen about 60%. He declined to provide specific assets under management dedicated to emerging markets, citing company policy.

“Years ago, investors could ignore emerging markets and it didn't particularly matter,” Mr. Leventhorpe said. “Given the fact that returns in emerging markets have tended to outpace developed markets and that emerging markets now account for about 12% (of the global market capitalization) — it becomes much harder to ignore.”

Demand for developing market equity will remain robust, consultants and managers said, but what's becoming increasingly important for emerging market equity managers is to add alpha from a bottom-up perspective. “In the past, there has been more top-down, country-specific value to be had” for active emerging market managers, said Deborah Clarke, principal in the manager research division of Mercer LLC based in London. “That's diminishing. What we're seeing more now is a bottom-up approach.”

Peter Preisler, director and head of Europe, Middle East and Africa at T. Rowe Price based in London, said the firm's bottom-up emerging market strategies have grown nearly fivefold in as many years to $18.3 billion in assets under management as of June 30, compared with about $4 billion in June 2004. The firm added Middle East and Africa strategies about two years ago, but stayed away from “four-letter type strategies, such as BRIC.”

“We think it has limited appeal to institutions, which tend to use regions as building blocks as part of a broader strategy,” Mr. Preisler said. “Why should one want to invest in Brazil but not Chile,” he added, “or China and India but not Thailand and Indonesia?”

AXA Rosenberg Group LLC — also a bottom-up equity manager — added a dedicated global emerging market strategy three years ago. As of June 30, the strategy had $1 billion in assets under management, up from about $700 million at year-end 2008. The firm has another $2.1 billion in emerging market assets within broader global strategies, which is also gaining inflows.

“Clearly more money is finding its way into emerging markets,” said Simon Vanstone, Europe CEO at AXA Rosenberg based in London. “Are people increasing on a tactical basis? Yes. My sense is that in the last year, there has been an increase to emerging market strategies, although more commonly as part of a wider global or international remit.”