Emerging markets equity at capacity wall

As many as half of the most sought-after emerging markets equity managers have closed their strategies, many at the end of 2010.

The reasons: years of strong performance and inflows from institutional investors.

Looking to these rapidly growing economies to boost equity returns, investors have crowded into long-successful strategies. And in emerging markets, which are smaller — and at times less liquid — than developed ones, capacity is more constrained.

As a result, finding a quality, experienced emerging markets manager is getting more difficult.

That was the experience of The Vanguard Group Inc. when the cost-conscious manager sought subadvisers for its Vanguard Emerging Markets Select Stock fund, a retail fund expected to be launched by the end of June.

Closures have “narrowed the field considerably,” said Dan Newhall, principal, portfolio review group, at Vanguard, Malvern, Pa. “Many have closed or grown their assets so large it wouldn't really make sense for us to engage their services,” both because of limited remaining capacity and less of an interest in negotiating fees.

About one manager in four has closed its strategies to new investors in recent years, with a flurry at the end of 2010, said Debbie Clarke, partner and global head of the equity manager research boutique at Mercer LLC, London.

“A lot of our highly rated managers have closed,” Ms. Clarke said. “At the margin, it makes it harder to find quality (institutional) managers.”

“The list is shrinking,” agreed Ulla Agesen, U.K. head of equity manager research at Aon Hewitt in London. She said that as many as half of the strategies recommended to clients have closed over the years.

“There are always new ideas, but it is clear that a number of the good (strategies) have closed,” she said. “That doesn't mean there aren't other opportunities, but less so.”

Paris-based emerging markets equity specialist Comgest SA stopped actively marketing to new clients in December, while William Blair & Co. LLC is considering closing its strategy to new clients, too.

Comgest has not closed its flagship global emerging markets growth equities strategy, but since December, “we are respectfully declining to participate” in searches, said William Holmberg, manager of investor relations. The firm ran $12.9 billion in the strategy as of Dec. 31, up from $5.1 billion three years earlier, according to eVestment Alliance, Marietta, Ga. Mr. Holmberg said the decision was made to stop actively marketing the strategy following “significant” inflows in 2010. “While we were not blind to what's going on in the markets, it was mainly a bottom-up decision” based on limiting ownership stakes in individual companies, he said.

Comgest declined to provide flow data, but assets in the strategy grew by $5.5 billion in 2010, according to eVestment. Comgest's average annualized returns for the 10 years ended Dec. 31 were 19.85% vs. 15.89% for the MSCI Emerging Markets index. That ranked Comgest in the 22nd percentile among eVestment's universe of 98 strategies.

Simo Sorsa, London-based emerging markets equity research analyst at Russell Investments, said limiting flows from new clients “is very much correlated with good performance. They've generally got good performance, long track records, are well known and have good distribution.”

Aon Hewitt's Ms. Agesen added: “We generally favor those managers that have a very clear view on what assets they can manage in their particular region or style,” so capacity is a major issue when reviewing emerging markets managers. “It is a question that is on top of our list — when are you going to close,” she said.

William Blair & Co. is considering closing its $4 billion emerging markets equity strategy, in large part because of capacity constraints of investing in midcap and small-cap companies.

“We have told clients and consultants all along about our capacity constraints because of our inclusion of small-cap and midcap in our strategies,” said Jeff Urbina, principal and portfolio manager at William Blair in Chicago. The firm closed its international small-cap strategy for capacity reasons on March 31. Emerging markets equities make up 25% of that strategy's holdings.

Like other managers with emerging markets strategies, William Blair has seen significant asset growth and strong performance. The firm's emerging markets strategy delivered an average annualized 20.02% for the 10 years ended Dec. 31 vs. 15.89% for the MSCI Emerging Markets index, according to eVestment Alliance. That puts William Blair in the top quintile for the decade among eVestment's universe of 98 strategies.

William Blair started an emerging markets strategy that invests in large-cap companies in April 2008. That strategy, which is not as susceptible to capacity constraints, returned 24.65% for the year ended Dec. 31 vs. 18.34% for the MSCI Emerging Markets Large Cap index.

Aberdeen Asset Management, First State Investments, Lazard Asset Management LLC and Robeco Group NV all closed their emerging markets equity strategies to new clients more than a year ago.

Managers noted that they need to limit inflows into emerging markets strategies often to protect capacity for other strategies they run — for example, a global equity strategy that also invests in emerging markets, or, in William Blair's case, the overlap of international small caps. “(Capacity) needs to be seen at a firm level, not just as an individual strategy issue,” Aon Hewitt's Ms. Agesen said.

Although capacity constraints are the main reason managers close strategies to new clients, several other factors come into play as to why and when a certain manager might shut the spigot of new inflows: The manager's investment process, investment horizon and even business pressures contribute, consultants said.

“If you are a value manager and buy and hold stocks for a long time,” capacity pressures will be less than those on higher-frequency trading managers, Russell's Mr. Sorsa said. “That number (at which a manager will limit inflows) is very dependent on your (investment) style.”

Market conditions also play a role, and entry points matter. At the end of 2010, stock prices in emerging markets had become a bit stretched, plus inflows picked up as more investors started to see the need for exposure to emerging markets. As performance of emerging markets equity started to decline and slip behind that of developed markets last fall, equity managers might well have stopped taking new clients to avoid poor performance from the start for the new clients.

“There's the risk that when you take on (a new mandate when valuations are stretched) your client expectations could be quite tough. So the conclusion is, "perhaps we ought to be sure we're taking on clients who are investing for the long term,'” Ms. Clarke said.

Consultants said the effect of narrowing the field of quality strategies caused by capacity constraints is being countered by the introduction of new strategies, such as hedge funds starting long-only equity strategies.

Robeco, for example, closed fundamental emerging markets equity strategies in November 2009 and February 2010, but the firm has added quantitative strategies, including a low-volatility one in February, that offer completely new capacity to the fundamental ones, said Wim-Hein Pals, head of emerging markets equities at Robeco.

Also, new public companies are popping up all the time in emerging markets. “That will help to alleviate the capacity problems,” Mr. Sorsa said.