Explosion looms for emerging markets equities

Emerging markets equities could get as much as $8 trillion in new institutional investment over the next 20 years as pension funds and other institutional investors are seen possibly tripling their allocations to the asset class by 2030.

“The trend (to raise emerging market allocations) is what we've seen and expect going forward,” said Will Tsui, senior investment professional at Hewitt EnnisKnupp, a Chicago-based investment consultant.

The growth in emerging markets equities is driven by a projection that the asset class will overtake developed markets to have the largest share of the global equity market, according to new research from Goldman Sachs Group Inc.

Aggregate emerging markets equity allocation among investors based in developed markets will rise to at least 18% by 2030, from the current 6%, predict Timothy Moe, Goldman Sachs chief Asia Pacific regional equity strategist, and Caesar Maasry and Richard Tang, both members of the Asia Pacific portfolio strategy team, and co-authors of a 48-page report, “EM Equity in Two Decades: A Changing Landscape.”

That increase would mean those investors could purchase at least $4 trillion in emerging markets equities over the next 20 years — and could be as much as $8 trillion if “only moderately higher assumptions” are used for real growth in assets and emerging market allocations, they wrote in the report.

By 2030, emerging markets equity capitalization would rise to $80 trillion, or a 55% share of global equity, the authors estimate. By contrast, developed markets could rise to $66 trillion, or a 45% share of global equity.

A Mercer Inc. statement on a study released Sept. 16 contends, “Institutional investors are limiting returns and retaining unnecessary risks in their equity portfolios by continuing to bias investment toward developed economies.”

“The continued strong growth in developing countries with favorable features such as young and expanding populations is not being captured adequately by many investors.”

Among Hewitt EnnisKnupp clients, large corporate and public pension funds, “the (emerging markets equity) search activity has definitely been more brisk than two years ago,” said Mr. Tsui, who hadn't seen the Goldman Sachs report.

In the past 12 to 15 months, Hewitt EnnisKnupp has conducted 15 to 20 searches with portfolio mandates ranging from $5 million to $200 million, Mr. Tsui said. Most of the activity has been for global equity strategies that include discretion to allocate some assets to emerging markets, while some have been for emerging markets equity specifically, Mr. Tsui said.

According to Eager Davis & Holmes LLC's tracking analytics, 36 searches for emerging markets equity managers were conducted in the first six months of this year, compared with 41 for all of 2009. However, $592 million was placed in the first six months of this year, compared with $1.7 billion for all of last year.

For global equity, which often includes an emerging markets weighting, searches for the first six months of this year totaled 19, compared with 46 for all of last year, according to Eager Davis & Holmes' analytics. The amount placed in the first half of 2010 totaled $1.08 billion, compared with $7.5 billion for all of last year.

The amount placed “has fallen in emerging markets and global equity for two reasons,” explained David Holmes, partner at the Louisville, Ky.-based firm. “First, fund sponsors are more often using multiple managers in "similar' mandates, presumably for manager diversification. They are also differentiating within these broad style categories to include, for example, small-cap, growth or value. Second, smaller funds are accounting for a larger portion of search activity in 2010.”

Hewitt EnnisKnupp's Mr. Tsui said the issue of increasing an emerging markets allocation “is a discussion we've been having with a lot of clients.”

“We have been urging our clients to adopt a more inclusive benchmark like the MSCI All-Country World index,” which includes a weighting to emerging markets, Mr. Tsui said. “We prefer to give skillful managers leeway to invest all over the world. It broadens their scope and ... improves their success.

“Our position is that emerging markets is an important component of the overall global economy and global investible universe, and as such investors should include emerging markets in their total plan investments,” Mr. Tsui said. He declined to recommend a range for an emerging markets equity allocation.

“Historically clients have accessed emerging markets for diversification purposes,” Mr. Tsui said. “But more recently, correlation of emerging markets (equity) to developed markets (equity) has increased, so diversification benefits are not as high as in the past.”

Emerging markets equities “offer investors attractive potential returns, but will require a greater allocation of business resources,” the Goldman Sachs analysts wrote in the report. “Financial intermediaries have substantial revenue opportunities, but will need to localize further; operating costs and competitive pressures will rise.”

The Goldman Sachs analysts estimate the overall global equity market would rise to $146 trillion by 2030. Its present value of $44 trillion consists of 69%, or $30 trillion, from developed markets and 31%, or $14 trillion, from emerging markets.

China would surpass the U.S. in equity market capitalization terms by 2030 and become the single largest equity market in the world. China's market cap of mainland- and Hong Kong-listed equities could rise to $41 trillion, or a 28% share of global equity, by 2030 from $5 trillion, or an 11% share, now.

By comparison, the U.S. equity market would rise more slowly to $34 trillion, or a 23% share of global equity, in 20 years from $14 trillion, or a 32% share, now.

The rise in market capitalization for emerging markets equities amounts to a 9.3% compound annual growth rate for 20 years through 2030, compared with an expectation of a 4% growth for developed markets equity market value, Messrs. Moe, Maasry and Tang wrote in the report. Over the past 20 years, emerging markets equity market value has grown at a 15.9% compound annual growth rate, compared to an annualized 6.5% for developed markets.

Messrs. Moe, Maasry and Tang couldn't be reached for comment about their report, released Sept. 9.

In terms of annualized total return, over the 20 years ended June 30, the MSCI Emerging Markets index returned 9.63%; the MSCI World index, which consists of only developed markets, including the United States, 5.79%; and the Standard & Poor's 500 index, 7.66%, according to MSCI Barra data.