Emerging market pains persist

Active money managers with heavy exposures to emerging markets are bracing for more pain, even as rock-bottom valuations suggest a turnaround may be in store for 2016.

Debt and equities strategies invested in developing economies have been persistently underperforming their developed market equivalents, leading to asset outflows at levels not seen since the financial crisis. As a result, shares in publicly listed managers with an emerging markets bent have been pummeled.

For example, share prices of Aberdeen Asset Management Inc., Franklin Resources Inc. and Ashmore Group PLC have fallen about 30%, 32% and 16%, respectively, in the six months through Dec. 18. By comparison, the MSCI World Financials index lost about 10% during the same period, according to Bloomberg data.

Unlike the largely retail emerging markets outflows during the “taper tantrum” two years ago after the Federal Reserve indicated the imminent reduction of its quantitative easing program, 2015's capital flight is more institutionally driven, said Robin Koepke, economist and expert on global capital flows at the Institute of International Finance, Washington.

Data from eVestment LLC indicate institutions pulled about $8.6 billion from emerging markets fixed-income strategies in the three quarters through Sept. 30, compared with net inflows of $16.5 billion during the same period two years ago. Leading the way are public pension funds, sovereign wealth funds and superannuation funds. Emerging markets equities fared little better, accounting for $4.3 billion in net institutional outflows compared with a $24.7 billion net inflow during the same period in 2013.

“The question is how long (emerging markets underperformance) will continue and what can be done” to mitigate further deterioration, said Jeffrey Levi, partner at money manager consultant Casey Quirk & Associates LLC, Darien, Conn.

Several factors — including the Federal Reserve's first interest rate increase for nearly a decade on Dec. 16, China's slowing economic growth and “lower for longer” oil prices — are contributing to fears that more turmoil might be ahead for emerging markets. As a result, some money managers with a sizable emerging markets business — whether through dedicated strategies or as part of their global and international portfolios — are slashing operating costs to help protect profitability, consultants said. They're also investing in new strategies to help plug outflows elsewhere.

“M&A is critical as (emerging markets) managers attempt to diversify away from their core capabilities,” said Mr. Levi.

Aberdeen, for example, announced four transactions in the past six months to diversify its business, but the size of the deals will barely make a dent in rebalancing its assets under management. U.S. private equity manager FLAG Capital Management and U.S. hedge funds-of-funds firm Arden Asset Management will add £4.4 billion ($6.7 billion) and £6.5 billion in AUM, respectively, to Aberdeen, which had £283.7 billion in AUM as of Sept. 30. Pending regulatory approval, other deals include Parmenion Capital Partners LLP, a U.K. digital investment solutions business, and Advance Emerging Capital Ltd., a small U.K. asset manager with frontier market capabilities.

Meanwhile, Aberdeen has registered net outflows for 10 consecutive quarters, hurt not only by the emerging market rout but also lower demand for its value investing approach. About 58% of Aberdeen's total revenue still largely depends on equities, dominated by three strategies: emerging markets, Asia-Pacific and global equities, which count emerging markets as a key performance driver.

“We're not diversifying away from emerging markets; we're very happy with our emerging markets business,” said Martin Gilbert, CEO of Aberdeen in London.

“What we want to do is to build the other businesses. What we'd like is for each of the "legs' of the company to have scale.”

The company also bid for U.S. real estate manager Bentall Kennedy Group, which has about $28 billion in AUM, but lost out to Sun Life Financial Inc. Additional U.S. real estate capability remains on Aberdeen's wish list, along with finding “infill on capabilities we don't yet have” in the solutions business, Mr. Gilbert said. “It's not easy right now with everyone else looking for acquisitions.”

Franklin Resources also is in an acquisitive mood after AUM plummeted 14% to $770.9 billion because of market depreciation, net outflows and currency movements in the fiscal year ended Sept. 30. The majority of the company's equity and fixed-income assets are invested in emerging markets, Asia-Pacific and global or international strategies. CEO Greg Johnson said during an analyst call that the company is actively searching for potential targets in areas such as alternatives or smart beta to further diversify its business.

“We look at everybody out there,” Mr. Johnson said. “If something gets us there faster, or is complementary, we are open to doing an acquisition.”

In addition, costs excluding sales and distribution will be trimmed about 4% in the coming year. Additional cuts would be considered if market conditions worsen, he said.

Ashmore also has reduced costs, for example, shutting its Brazil business earlier this year. Excluding salaries, depreciation and amortization, operating costs decreased about 8% during the fiscal year ended June 30, according to its annual report. During the same period, AUM at the emerging markets debt specialist dropped 21% to $58.9 billion and has fallen even further since.

Executives at both Ashmore and Franklin Resources declined to be interviewed for this story.

Money managers dependent on emerging markets performance face a triple whammy in their revenue base:

nReduced revenues from management fees as market movements and investor redemptions shrink the asset pool. Losses are partly offset by favorable currency movements because fees are often calculated in dollar terms.

nLower demand for underperforming strategies that could force some managers to cut fees to attract or retain assets, further hurting revenue. Compared with 2010, for example, management fees have been reduced by about 10 basis points to 20 basis points on average for some broad-based emerging market equities strategies, according to Towers Watson & Co. estimates.

nIncreased market volatility also makes any outperformance relative to an index more challenging, potentially resulting in lower performance fees.

Additionally, institutions are managing their emerging market portfolios differently, moving away from strategies dedicated to gaining broad-based exposures to developing economies, said Iain Douglas, head of emerging markets equity manager research at Towers Watson in New York. Because such strategies often command relatively higher fees, those managers could suffer further revenue declines.

“Even when investors are not necessarily reducing emerging markets exposure in terms of size, they might think differently about how they're allocating that exposure within the overall portfolio,” Mr. Douglas said, referring to a shift into more global investment strategies or alternative emerging market assets. “A traditional, moderately active dedicated emerging market strategy may not be the best use of capital.”

After total returns for the MSCI Emerging Market index plunged about 15% in U.S. dollar terms this year through Dec. 18, compared with to -2% for the MSCI World index, managers are seeing valuation levels that could draw institutional investors back into the fold.

Aberdeen's Mr. Gilbert believes emerging markets are poised for a strong recovery. The company's global equities strategy, for example, maintains an overweight position in emerging markets on average, at the expense of U.S. stocks.

Increased volatility could result in higher alpha generation, said Alper Ince, managing director and sector specialist for long/short equity and event-driven equity at Pacific Alternative Asset Management Co. LLC, Irvine, Calif. PAAMCO's exposure to hedge funds focused on emerging markets has been steady, but is positioned to leave enough “dry powder” to take advantage of attractive valuations, he said.

Most institutional investors are committed to emerging markets for the long term, he said. “Nevertheless, they're raising more questions.”