Emerging markets are facing a period of structural reform that will leave asset owners adopting a much more selective approach to investing in those markets, said a report from London-based CREATE-Research sponsored by Principal Global Investors LLC.
Based on a survey of 704 pension plans, sovereign wealth funds, pension consultants, asset managers and fund distributors around the globe, the report concluded that demand for broad, passive global emerging market exposure will fall, with investment focusing on the countries making the necessary reforms to fuel the next stage of growth.
Andrea Muller, Singapore-based CEO of Principal Global Investors Asia, cited the outflows that hit certain emerging markets particularly hard when U.S. Federal Reserve Board Chairman Ben Bernanke first mentioned "tapering" in May 2013, as a harbinger of the now growing recognition that "all these markets are not equal."
Survey respondents said the two main drivers of asset prices in emerging markets will be slower economic growth (62% of respondents), as well as the Federal Reserve's taper program, cited by 53% of respondents.
The survey showed expected annualized returns on emerging market equities investments over the coming 10 years at 9%, besting other major asset classes, but declining from an annualized 14% for the latest 10 years.
Expectations for returns from emerging markets bonds showed even bigger proportional declines, at 4% for both hard currency bonds and local currency bonds, down from 9% and 10%, respectively, for the prior 10 years.
In line with the report's conclusions, Ms. Muller said Principal Global Investors has been seeing fewer RFPs for global emerging markets investments in Asia this year. But otherwise, she said, business in the region remains very active, with "a lot of money in motion."
Forty-eight percent of survey respondents see emerging markets equities to be an opportunistic play, compared with 30% in 2012, while 51% of respondents find emerging markets debt to be similarly opportunistic, up from 15% in 2012.
Frontier markets in Africa should generate the best returns behind only the U.S. over the next three years, the report said. Respondents also expect emerging and developed markets to continue to converge.
Fifty-six percent of respondents expect more market structure convergence between the East and West, and 32% expect more convergence in terms of investor approaches.
“I think the most important takeaway again is just the convergence between emerging and developed economies and we have definitely seen that play out after the global financial crisis. Institutional investors, especially outside of the U.S., have been moving to global all-country-type benchmarks. They have been wanting managers to manage across emerging and developed economies jointly and find the best opportunities,” said Barb McKenzie, chief operating officer of Principal Global Investors, in a telephone interview.
When asked which regions would offer the best returns in the next three years, 47% of respondents said the U.S. would be most likely to do so, followed by 45% saying frontier markets in Africa.
“There is absolutely a growing interest in frontier markets, especially Africa,” said Ms. McKenzie. “People are looking at it as a way to get greater diversification. The African continent — ex-South Africa — is a rapidly developing resource, which we're seeing on the institutional side the creation of sovereign wealth funds around the continent.”
Of the largest emerging markets, 34% said China, and only 15% said Brazil, will offer the best returns over the next three years.
Expectations for global equity returns slipped to 5% for the coming 10 years from 8% for the prior 10 years, with real estate dropping to 7% from 9%; global sovereign bonds to 2% from 4%; high-yield bonds to 5% from 8%; and cash to 1% from 2%.
Ms. Muller pointed to real estate — with its combination of solid returns, relatively low volatility and ability to serve as a hedge against inflation — as a market segment attracting growing interest this year.
She cited growing demand from Asian clients, including a number of institutional clients in Korea, for direct investments in U.S. commercial real estate and in Europe as well over the past year.
For such direct investments, Principal Global arranges the deal and then serves as the building manager “to produce a particular yield," she said. Principal Global has managed direct investments for Korean investors in Houston and Washington, with other markets under consideration as well, she added.
She said there's growing interest from clients in Asia for a number of other real estate investment vehicles, including a commingled property fund, global real estate investment trusts, amid growing opportunities for investment in North Asia, and Japan in particular, as well as demand for Principal Global's real estate debt fund.
On the global equity front, she said Principal Global is seeing more RFPs now for global equities mandates with an income element, as well as absolute return strategies, cash- or inflation-plus fixed income mandates as well as growing interest in hedge fund mandates.
More than 700 executives at pension plans, money managers, sovereign wealth funds, pension plan consultants and fund distributors across 30 countries representing $29.7 trillion in assets were surveyed in January and February.
The full survey results are available on Principal's website.
