Single-country funds losing out to broader investment mandates
As emerging market countries struggle with their own troubles, investors are shunning single-country allocations in favor of broader exposure.
Money managers said a combination of domestic issues, rising U.S. interest rates and a strengthening U.S. dollar is creating a perfect storm for emerging market countries. Following months of inflows to single-country strategies, some managers now are seeing outflows — at the same time they're seeing inflows to global emerging market allocations.
The latest emerging market to hit headlines is Turkey, which amid economic woes and a trade spat with the U.S. has seen its currency, the lira, drop 7.76% against the dollar between Aug. 9 and Aug. 17, and 44.82% since the start of 2018.
Data from provider EPFR Global for the week ended Aug. 1 show global emerging markets equity strategies recorded their biggest inflows in more than three months, at $895 million. That followed almost $3.5 billion in net outflows for the entire four weeks preceding that period.
In contrast, about half of emerging markets country strategies posted outflows, for the week ended Aug. 1, EPFR reported.
Money managers agreed conditions are encouraging investors to move toward the less risky end of emerging markets allocations.
Emily Whiting, emerging markets and Asia-Pacific equities investment specialist at J.P. Morgan Asset Management (JPM) in London, said inflows to emerging market countries dwindled after a number of "worries" hit in 2018. It started around late March with Russia — and since then, political, economic and geopolitical issues have sprung up in Argentina, Brazil and Turkey.
"Think of it as a pyramid — the bottom is most stable, (that is) global emerging markets," Ms. Whiting said. Moving up the pyramid, taking more risk, investors allocate to regional and then to single-country strategies.
And as investors become more cautious, they take from the top of the pyramid.
"As people move out they take from the risk. They still want to be exposed, but leave it to the managers to work out where to be," she said. "We have seen net positive inflows into all of our GEM products so far this year, whereas we have seen outflows in the likes of Latin America, emerging Europe, India and so on. We can see that as people start to derisk, they go from single country" to broader allocations, she said.
While money managers and investors long have stated the case for emerging markets to be judged on their own merits, rather than as one homogeneous group, diversification still appears to win out when volatility rises.
"Idiosyncratic risk is on the rise in EM due to elections (and) geopolitics, so it's more optimal to have a diversified portfolio" where a portfolio manager can run risk more directly, managing volatility and downside risk, said George Varino, head of emerging markets solutions in New York at Investec Asset Management. "We are in a period of time where uncertainty is on the rise, and it just makes sense to choose strategies with more diversification." The firm does not publicly disclose a breakdown of assets under management.
Still believing in value
Investors still believe in the long-term value of emerging markets as part of a strategic asset allocation, said Edward F. Keon Jr., a portfolio manager and chief investment strategist for Quantitative Management Associates LLC's global multiasset solutions team based in Newark, N.J.
"But the problems with individual markets have been dramatic in 2018. Some were driven by global issues, but in some cases local issues that might be difficult for global investors to handicap were culprits. For now, investors might have concluded that a broadly diversified EM exposure might be more prudent than trying to call the bottom in troubled markets."
QMA has $5.5 billion in assets under management in emerging markets.
The difficulties in making choices among the various EM countries also are evident in performance figures. In U.S. dollar terms, the MSCI Poland index gained 55.31% in 2017, and 0.69% in 2016. The MSCI Brazil index returned 24.11% in 2017, and 66.24% in 2016. And the MSCI Mexico index gained 15.97% in 2017, but lost 9.16% in 2016.
"I believe it is entirely understandable that there should be a long-term switch toward global emerging markets funds and away from region- or country-specific funds," said Kim Catechis, head of global emerging markets at Martin Currie Investment Management Ltd. in Edinburgh. "This is mainly due to the recognition by asset owners of the challenges of asset allocation within emerging markets. Performance data over the last decade should demonstrate that there is a persistent polarization of returns, thus raising the risk of a poor asset allocation call."
"It's not just down to idiosyncratic risk," said Daniel Morris, senior strategist at BNP Paribas Asset Management in London. "Higher allocations to broad GEM funds at the expense of country funds are not surprising.
"While idiosyncratic risks have played a role, as they always do in emerging markets, the key development this year has been the rise in U.S. interest rates combined with a stronger dollar," he added.
There might be another reason for choosing wider emerging markets allocations. "There may also be a renewed search for alpha, which means allocating to funds with a broader EM mandate," said Peter Kisler, London-based portfolio manager of the North Emerging Markets fund at North Asset Management LLP. Assets under management were not available.
"At the moment, there are very few EM 'darlings' left, but global liquidity remains ample, pushing money into broader, more diversified investments, rather than individual stories," he said.
However, Mark Mobius, partner at Mobius Capital Partners LLP in Singapore, said foreign investors are becoming more discerning.
"Now they differentiate between Turkey and Vietnam, Vietnam and South Africa, South Africa and Poland. They make more specific investments. That's the reason why the so-called contagion from Turkey will be quite limited," he said.
Keeping investments up
Despite the seeming trend, one group increasingly anchoring flows to single-country strategies are domestic investors, those located in the emerging market themselves.
"Brazil pension funds still have over 90% of their assets in local assets," said Christoph Hofmann, New York-based global head of distribution at Ashmore Group, London. "That doesn't always show up in flow numbers, but forms an increasingly large number as pension systems (in those markets are) developing rapidly."
Mr. Hofmann said domestic buying "has such a strong impact, is such an anchor, that international flows in those markets are playing a much smaller role than they used to."
The rise of the local investor has led Ashmore to increase its presence outside the U.K. capital.
"The world has moved on and the wealth creation in emerging markets themselves has had such an impact." Now, less than half of Ashmore's headcount is in London, with the remainder in other time zones and most in emerging markets, compared with 20 years ago when "99.9% of our headcount would have been in London," Mr. Hofmann said. The emerging markets specialist has $73.9 billion in assets under management.
Figures provided by Allianz Global Investors showed non-domestic local bond holdings across emerging markets was the highest in South Africa, at 40.2%. The lowest is China at 2.2%, while foreign investors hold 11.9% of Brazil local bonds and 19.6% of Turkey's local bonds.
Richard House, chief investment officer for emerging market debt at AllianzGI in London, said domestic investors buying up local bonds has been a developing trend over the past decade.
"Investors that played emerging markets local bonds were mainly foreigners or banks, but pretty much every country in an emerging market now has a pension fund system and flows have to find a home. They've become a much more significant driver of the asset class," he said.
And these domestic investors give Mr. House "more comfort" — something that is particularly welcome given the current situation in Turkey.
"It feels like an old-school emerging markets crisis. (Previously) it would have caused a lot of contagion in markets. That type of across-the-board asset class contagion doesn't happen like it used to, and the reason I think is because domestic investors … are the owners of these bonds. That anchor is there and it's becoming a powerful thing," Mr. House said.
Angus Bell, senior portfolio manager, emerging market debt at Goldman Sachs Asset Management in London, said, "It's natural to expect that as these economies expand and develop, their domestic financial systems will also grow consistent with higher savings levels."
He said improvements in domestic policies, such as stronger institutional quality, more robust regulatory frameworks and better implementation of more flexible macro policy tools such as floating foreign exchange regimes "have also been important in creating a healthier and more encouraging backdrop to absorb the rise in domestic savings."
An emerging opportunity
As the middle class grows in these emerging markets and savings and flows increase, there is another potential opportunity for money managers. Existing retirement systems are now "diversifying away (from their home bias) – they do hire external managers to run some of their pension pots, and that will be a trend as well," Mr. Bell said.
North Asset's Mr. Kisler added: "It should be noted that EM interest rates in countries like Brazil and Russia have fallen in the past few years, and local money is looking for new ways to invest, as bank rates are half of what they used to be. Some of that money naturally finds its way to EM funds and into broader EM mandates."