Emerging market investors looking beyond equities

As institutional investors ratchet up their allocations to emerging markets, they're looking beyond equities to portfolios designed to allocate risk across different asset classes within developing economies.

Public equity remains the dominant route to gaining exposure to emerging markets, according to consultants, managers and fund executives. However, institutional investors are now beginning to focus on building more balanced emerging markets portfolios that also include emerging markets debt, currency and other alternative investments. Even within the equities strategy, investors are emphasizing diversification rather than eye-popping returns.

“Investors in emerging markets should, and are increasingly, seeking to understand, manage and decompose the risk factors in their portfolios,” said George Hoguet, managing director, senior emerging markets portfolio manager and global investment strategist at State Street Global Advisors based in Boston.

At the $41 billion Juneau-based Alaska Permanent Fund Corp., executives recently appointed Capital Guardian Trust and are in the final stages of reviewing Pacific Investment Management Co. LLC with the idea to split an $820 million multiasset emerging markets portfolio. Under the new multiasset mandate, managers have discretion across risk factors and asset classes to invest not only in equities but also emerging markets debt, currency and other alternative public emerging market securities, said Jeffrey Scott, the fund's chief investment officer.

“It's safe to say that, based on emerging markets' share of the global (gross domestic product), most public institutions have a tremendous (home country) bias,” said Mr. Scott. “Emerging market countries are contributing north of 40% of global GDP, yet most public institutions are invested primarily in the developed markets.”

“However, it doesn't mean that emerging markets will give you better risk-adjusted returns. You still have to do your homework and assess the current valuations,” Mr. Scott said in a telephone interview. “Do we believe in the emerging markets story in the long term? Yes. ... We anticipate greater weight to emerging markets and increased diversification across risk premia relative to the existing portfolio composition.”

Alaska Permanent currently has a 7% allocation to all emerging markets strategies.

Among U.S. pension funds, the average allocation to emerging markets equities and debt is about 4.5% and 1.7%, respectively, as of Sept. 30, 2010, according to a Pensions & Investments analysis from data provided by plan sponsors. While this is an increase from the 3% exposure to emerging markets equities and 1% to emerging markets debt three years earlier, the allocation is still small relative to the economic growth potential of those economies, sources said.

Emerging markets account for 13.8% of the MSCI All Country World index, a cap-weighted index comprising developed and developing market stocks.

“On average, U.S. DB pension funds are about 50% underweight in emerging markets relative to the typical cap-weighted (global equities) benchmark,” said Kathryn Koch, London-based senior portfolio strategist and chief of staff for Jim O'Neill, chairman of Goldman Sachs Asset Management.

Emerging markets debt, which is increasingly sought by investors as an investment diversifier, accounts for about 3% of the J.P. Morgan Global Aggregate index. Frontier market equities still account for a relatively modest portion, or less than 1%, of the $23 trillion world market capitalization. The majority of institutional investors do not have a dedicated frontier markets strategy, but some may have exposure to the asset class through broad global emerging markets mandates.

“Frontier markets do exhibit lower correlation to the broader emerging markets,” said Jose Gerardo Morales, CIO for Mirae Asset Global Investments (USA) LLC. Mirae has about $53 billion in assets under management globally, about $30 billion of which is invested in emerging and frontier markets.

In a separate survey of Pensions & Investments' Research Advisory Panel, consisting of executives at pension, endowment and foundation funds as well as investment consultants, 43% estimated their funds would have emerging markets exposure between 6% and 10% in five years. Another 20% of the respondents believed emerging markets exposure would be between 10% and 15%, while 11% said the likely allocation would top 15%, according to the survey, which was conducted April 26 to May 2 and included 128 respondents.

“The story of emerging markets is not going away; it's much more accepted today relative to a decade ago,” said Cynthia Steer, managing director of investment strategy at Russell Investments, Seattle.

Equity strategies are experiencing stronger flows, Ms. Steer said, and fund executives are considering other asset classes. “Institutional investors have been looking at the emerging markets landscape from the equity perspective,” Ms. Steer said. “Now that they've understood sovereign risk better, and that emerging markets (sovereign bonds) are really investment grade and cannot be linked to high yield, many are now considering (bonds denominated in) local currency.“

“Debt inflows have started to rise,” Ms. Steer added, “and investors are looking at more illiquid asset classes.”

Emerging markets real estate investments will play a bigger role within the new real estate strategic plan introduced earlier this year by the Sacramento-based $230.1 billion California Public Employees' Retirement System. Within the non-core portion - accounting for 25% of the total $15.4 billion real estate strategy, about 15 percentage points will be invested domestically with the remainder largely targeting emerging markets such as Brazil, India and China.

In the U.K., dedicated emerging markets strategies account for about 5% of the total portfolio on average, according to analysis by GSAM. In continental Europe, particularly in the Nordic countries, investors have generally outpaced their U.S. and U.K. counterparts in dedicated emerging markets exposure. Many Nordic pension funds are either already overweight or are planning to do so relative to the MSCI ACWI benchmark in the near future. “I don't think many of (the clients) there have less than 10%” allocated to emerging markets, Ms. Koch said.

Many pension funds have been switching to a global equity approach that would also include some emerging markets exposure, sources said. Others have gained emerging markets exposure through developed market companies that have a large portion of their earnings potentially coming from emerging markets. For example, GSAM's European equity portfolio and U.S. equity strategy derive about 25% and 18%, respectively, of their total revenue from emerging markets exposure, according to data provided by the company.

However, some say investors can benefit from higher returns in the long term by directly investing in emerging markets companies rather than trying to benefit from developed market stocks with exposure to emerging markets. Wim-Hein Pals, executive vice president and head of emerging markets equities at Robeco, Rotterdam, Netherlands, said: “It's for the simple reason that while these (developed market) companies do benefit from higher growth in emerging markets, they're also exposed to lower-growth developed markets. So in a sense, you're watering down your opportunities by holding diluted exposures.”

Robeco has about e20 billion ($30 billion) in emerging markets assets under management, about two-thirds of which are managed for institutional clients. While unsettling events earlier this year — including political unrest in the Middle East and ongoing inflation concerns — have led to outflows among retail clients, Mr. Pals said assets under management from institutions remain “sticky.”

“Long-term institutions such as pension funds and sovereign wealth funds — they didn't sell a penny, and in some cases, added (to the emerging markets portfolio),” Mr. Pals said.

Tony Broccardo, CIO of Oak Pensions Asset Management — the internal fund manager of the £18.2 billion ($30 billion) Barclays U.K. Retirement Fund, decided to double its emerging markets exposure in the fourth quarter of 2008, when many other investors began to “batten down the hatches,” he said. The fund — based in London — has since seen its dedicated emerging markets exposure triple to about 9% within the £9.1 billion growth portfolio. (The remainder, or about 50% of the fund, is invested in a liability-driven investing strategy.)

As part of the dynamic asset allocation framework adopted by the fund three years ago, any additional allocation to emerging markets will be considered but “decreases wouldn't be ruled out either,” Mr. Broccardo said.

“Building diversified emerging markets exposure across different return drivers is as important as the actual overall allocation amount,” he said.

The fund has invested in emerging markets public and private equity, debt and currency. More than half of the dedicated emerging markets strategy is currently invested in public equity. The fund has been moving towards more equal weights of emerging markets exposures. “We want to make sure the drivers of returns are differentiated,” Mr. Broccardo said.

Mark Horne, senior investment consultant at Towers Watson based in London, said to fully capture the benefits of emerging markets growth, investors need to be diversified across equity, debt and currency.

“What we've found was that (the MSCI Emerging Markets index) has lower correlation to actual GDP growth than some other asset classes such as currency and emerging markets debt,” Mr. Horne said. One key reason for that is that in some countries, such as Russia, the main constituents dominating that market “may or may not be linked to the growth rate of the country,” Mr. Horne added.

Towers Watson is recommending an exposure of 7% to 15% to dedicated emerging markets strategies, depending on the fund's risk management level, governance requirements and other factors. “The appetite for gaining exposure to emerging markets has definitely been broadening, with more and more clients reaching that sort of level,” Mr. Horne said.

“At the same time, we're advocating a phased approach,” he said. “While the long-term objective (to increase allocation to emerging markets) makes sense, several factors such as the threat of inflation makes it more prudent to phase in the additional allocation.

Some pension fund executives believe the allocation to emerging markets should be even higher.

Ramon Tol, fund manager equities at Blue Sky Group Inc., Amstelveen, Netherlands, said the long-term growth potential for emerging markets is probably not reflected in its current 15% market capitalization weighting within the MSCI ACWI. Particularly when taking into account the financial strength of emerging markets governments and companies relative to many of their developed market counterparts, a premium valuation can be justified.

“As the contribution of emerging markets to the global GDP is higher, it deserves an allocation closer to 25%,” Mr. Tol said. Blue Sky Group has about e13.8 billion in assets under management, predominantly on behalf of KLM Royal Dutch Airlines pension funds.

As of April 30, about 18% of the Blue Sky's e5.8 billion equities portfolio was allocated to dedicated active global emerging markets strategies, and a separate 2% is invested in active frontier markets portfolios. Blue Sky plans to increase the total exposure to emerging markets and frontier markets to 25% over the next year at the expense of developed markets equities. The group is also considering investing in emerging markets on a passive basis for “a pure beta play,” Mr. Tol added. However a few short-term market factors, including inflation concerns, may temporarily affect the pace at which any decisions are executed.

In addition to Blue Sky's emerging markets equities strategy, the fund manager also has a 13% allocation to emerging markets debt — denominated both in local and hard currencies — within its e7 billion fixed-income portfolio. n

Data Editor Timothy Pollard contributed to this story.