Emerging markets investments climb 56%

U.S. pension funds' emerging markets assets rose about 56% to $128.5 billion in the year ended Sept. 30, according to the latest Pensions & Investments survey of the nation's largest retirement funds.

In the year ended Sept. 30, emerging markets equity assets reported by defined benefit plans in the P&I Top 200 rose to $115.1 billion, up 56.4% from $73.6 billion a year before. Emerging markets bond assets also rose 54% in the same period, to $13.4 billion.

Strong investment returns in both asset classes and changing risk dynamics of these rapidly growing countries fueled the rapid rise, experts said. Further growth is expected.

“People are recognizing the growth story and general financial health of the emerging markets relative to the developed markets in general,” said Michael P. Manning, president of investment consultant NEPC LLC in Cambridge, Mass. “There's probably a long wave of opportunity.”

Strong returns contributed to emerging markets asset growth. The MSCI Emerging Markets index rose 20.4% in the year ended Sept. 30, while the J.P. Morgan Emerging Markets Bond index rose 15.9% in the same period. Taking those returns into account, equity assets invested by the pension plans in the Top 200 still grew about 30% while emerging market fixed income assets rose around 33%.

The outperformance of emerging markets equity over developed markets “is remarkable,” said Scott P. Leiberton, managing director-equities at Principal Global Investors in Des Moines, Iowa. “It's been a huge outperformer for the past decade.”

The MSCI Emerging Markets index returned an annualized 10.8% in the 10 years ended Sept. 30 vs. -0.4% for the S&P 500 index and 0.2% for the MSCI Europe, Australasia and Far East index. Emerging markets bonds also outperformed over the past decade, with the J.P. Morgan Emerging Markets Bond index rising an annualized 10.5% vs. 6.4% for the Barclays Capital U.S. Aggregate Bond index and 7.3% for the Barclays Capital Global Aggregate Bond index (hedged).

Another contributor to the spike in emerging markets assets was new allocations from pension funds. As of Sept. 30, 91 of the defined benefit plans in the top 200 reported equity allocations and 25 had bond allocations to emerging markets, up from 79 equity and 20 bond allocations a year earlier.

The California Public Employees' Retirement System, Sacramento, held the most emerging markets equity assets in the survey at $11.01 billion. That was up just 2.6% from the $10.73 billion CalPERS had a year earlier, when it also held the No. 1 spot.

Major increases were seen elsewhere, however. Emerging markets equity assets at the DB plans of General Electric Co., Stamford, Conn., rose by 105.6% to $2.88 billion, while those at International Business Machines Corp., White Plains, N.Y., grew 51% to $1.93 billion. New Jersey Division of Investment, Trenton, saw emerging markets equity assets jump 186.8% to $3.6 billion, and Oregon Public Employees Retirement Fund, Salem, had a 124.7% increase to $2.8 billion.

Meanwhile, assets at the University of California Retirement System, Oakland, fell 25% to $1.63 billion, while those at the defined benefit fund of Dow Chemical Co., Midland, Mich., fell 15.6% to $805 million.

Among emerging markets bond investors, General Motors Co., Detroit, reported $2.6 billion of emerging markets debt assets as of Sept. 30; GM did not give a breakout of its assets the previous year. Similarly, the Commonwealth of Pennsylvania State Employees' Retirement System, Harrisburg, after reporting no emerging markets bond assets in 2009, reported nearly $1 billion in the most recent survey. In the same period, assets at Ohio Public Employees Retirement System, Columbus, rose 90.8% to $662 million, up from $347 million a year before.

Despite the significant growth in emerging market stocks and bonds, they together constituted just 3.5% of the $3.7 trillion of total assets of the 200 largest defined benefit pension funds as of Sept. 30. That's up from 2.4% of the $3.5 trillion total as of Sept. 30, 2009.

“Fifty-five percent of almost nothing still isn't very much,” said Jerome Booth, head of research at emerging markets specialist money manager Ashmore Investment Management Ltd., London. “Emerging markets are not at all properly represented in major benchmarks.”

Principal Global's Mr. Leiberton warned, too, that passive asset flows into emerging markets may be temporary or tactical investments. “I would watch that closely,” he said.

In the most recent survey, passive assets rose 39.2% to $14.2 billion vs. the 59% rise in active assets to $100.8 billion. The Teacher Retirement System of Texas, Austin, increased its passive emerging markets equity assets by 76.9% in the period, while its overall emerging markets equity assets rose 42%. Meanwhile, the Washington-based National Railroad Retirement Investment Trust's passive assets fell 71.9%, while overall emerging market equity assets rose 22.7%.

Experts said allocations to emerging markets will continue to rise, in part because of the changing perceptions of risk. While a series of crises in emerging markets caused investors to view them as being riskier than developed markets, “in the past decade you haven't had any profound crises in the emerging markets,” Mr. Leiberton said. “You've seen the opposite — all of the crises have been on the developed side.”

At the same time, countries in the emerging markets have gone from being net debtors to net creditors, making them less vulnerable to global economic shocks and better able to build domestic demand, experts said.

Ashmore's Mr. Booth argued that pension funds also need to invest in emerging markets for liability reasons, in order to preserve the purchasing power of pension benefits. “Increasingly, emerging markets are part of the liability structure of pension funds,” he said. “The prices of those goods (that retirees purchase) will be driven by emerging markets.”

Experts warned, however, that the increase in assets won't be smooth. “History shows that flows into emerging markets tend to be very performance-driven,” NEPC's Mr. Manning said. “I don't think it's going to be a steady climb.”