Emerging markets inflows slow as institutional investors become more cautious

The easiest sailing is over for emerging markets equities, and institutions are bracing for more choppy waters ahead.

While developing economies remain a crucial part of their equity portfolios, investors are becoming much more cautious following “a pronounced period of underperformance,” said Tapan Datta, principal and global head of asset allocation at Aon Hewitt, London.

“Investors are, in a sense, much more realistic about emerging markets” than they were three years ago, Mr. Datta said. “Excess optimism has left the asset class, and what remains is a better sense of what is achievable.”

So far this year, the MSCI Emerging Markets index lost 12.7% compared with a 5.3% gain for the MSCI All Country World index and a 12.6% increase for the Russell 3000 index. Emerging markets also underperformed both the MSCI ACWI and the Russell 3000 during the same period last year, returning 5.1% year-to-date as of June 20, 2012. In comparison, the MSCI ACWI returned 5.6% and the Russell 3000 rose by 8.9%.

Valuations have fallen to the point Aon Hewitt has changed its recommendation to an overweight position in emerging markets from an underweight stance within the past month. Northern Trust Corp. also is recommending an overweight position, stating the current 28% discount to world equities gives some valuation cushion, according to a paper published on June 19.

“We will continue to experience volatility, but the emerging markets story is still intact,” said Mark Mobius, Singapore-based executive chairman of Templeton Emerging Markets Group, a unit of Franklin Templeton Investments with $53.6 billion in assets under management. Speaking at a company-sponsored investment conference in London earlier this month, Mr. Mobius added the firm continues to see steady institutional asset inflows into certain emerging markets equities strategies including small caps and Asia growth. Frontier markets also have been attracting institutional assets.

According to data provider eVestment LLC, Marietta, Ga., institutional net inflows into emerging markets equities totaled $10.4 billion in the first quarter of 2013. That total is much less than the $19.4 billion figure recorded in the fourth quarter of 2012 and $26.5 billion in the first quarter of 2012.

Furthermore, most of the first-quarter inflows went to actively managed strategies. Unlike the trend toward passive management in the more efficient developed markets, active management is growing in emerging markets as investors increasingly seek selective exposures amid higher volatility. One area to watch would be certain defensive stocks or small caps, which potentially could provide better risk-adjusted returns.

Another tactic would be to invest in certain developed-market companies with significant income streams flowing from developing economies, said Ian Harvey, head of the institutional business at Neptune Investment Management, London, which has about £6 billion ($9.3 billion) in assets under management, including long-only emerging markets equities and global equities. Other factors — including currency exposures, which cannot be efficiently hedged — also need to be carefully managed.

“There has been a modest setback for emerging market currencies in the past six weeks. But in the long term, we absolutely see emerging market currency (exposure) as a rewarded risk,” said James Wood-Collins, CEO of Record Currency Management, Windsor, England, which has £22.9 billion in AUM.

In one of the latest examples of a move into active, the New Jersey Division of Investment, Trenton, decided earlier this year to shift $1 billion into an actively managed separate emerging markets equity portfolio out of emerging markets exchange-traded funds. Others searching for active emerging markets equities managers include the $15.7 billion Los Angeles Fire & Police Pension System and the $46.5 billion Alaska Permanent Fund Corp.

The sovereign wealth fund is planning to add to its overweight exposure to emerging markets, said Michael Burns, CEO of Alaska Permanent. “We're still convinced that emerging markets are going to grow faster than the developed economies of the world,” Mr. Burns added.

Real growth in emerging markets averaged 5% this year, Mr. Mobius said at the conference. Combined with strong capital reserves and relatively low debt-to-gross-domestic-product, “any short-term (market) fluctuations are not significant,” he said.

At Martin Currie Investment Management, its active emerging markets strategy launched in 2010 with a team acquired from Scottish Widows Investment Partnership has grown to about $1 billion in AUM, said Andy Sowerby, Edinburgh-based executive director and head of sales, marketing and client services. The strategy has outperformed the MSCI Emerging Markets index by about 300 basis points annualized over the past three years, gross of fees. Recent hires include a $250 million portfolio managed on behalf of the $25.5 billion Pennsylvania State Employees' Retirement System, Harrisburg.

“The key thing is that institutional investors globally are structurally underweight in emerging markets, so we expect that they will continue to increase that weighting (over the long term) given the size, the GDP growth rate and the increasing consumer base of emerging markets,” Mr. Sowerby said. Within Martin Currie's global alpha strategy, exposure to emerging markets also increased to 10.6% in June compared with 7.6% a year earlier.

As conditions improve from a valuation basis, some institutions see a good entry point for emerging markets, Mr. Sowerby added. “The inflow into active emerging markets is not a reaction to short-term volatility, it's a strategic rather than a tactical decision.”

However, other money managers are more skeptical, pointing to longer-term fundamentals driving them to underweight emerging markets. According to the latest BofA Merrill Lynch Fund Manager Survey, 9% of the managers surveyed in June are underweight emerging markets equities — the first time the survey recorded an underweight position since 2009. The move was despite an overall increase in equity allocations, with 48% of the managers reporting an overweight position in equities. Furthermore, 25% of the global managers surveyed said emerging markets is where they're most likely to be underweight in the next 12 months.

“We have come across a whole new set of issues in terms of accessing emerging markets,” said Gustavo Galindo, New York-based portfolio manager at Russell Investments who is responsible for the multimanager Russell Emerging Markets Fund.

Central among those concerns has been China, where lower-than-expected growth helped to send the Shanghai SSE Composite index down 7.6% so far this year and put a drag on broader emerging markets and commodities indexes, sources said. Political issues in nations including Brazil and Turkey are also making investors nervous.

“We've been quite negative on emerging markets for the past few years, and recent concerns over (the end of quantitative easing) have come on top of the negative view we already held,” said Maarten-Jan Bakkum, senior strategist in emerging markets equities at ING Investment Management, The Hague, Netherlands.

“Deteriorating growth prospects in China are key, but beyond China we see declining competitiveness, lack of structural reforms and regulatory risk rising in emerging markets,” Mr. Bakkum said. ING IM is underweight emerging markets within various global equities and multiasset portfolios. While the underweight levels vary, they're generally “about halfway to our maximum negative position,” Mr. Bakkum added. “I don't think we'll go back to an overweight position anytime soon.”

Remi Ajewole, London-based fund manager within the multiasset team at Schroder Investment Management, said the firm expects recent underperformance of emerging markets to persist in the short to medium term. “We're reassessing our outlook on emerging markets growth,” said Ms. Ajewole, adding the multiasset team has been underweight emerging markets in the past two years. “There's still a place for emerging markets, but we're not adding to our position right now.”

At Neptune, emerging markets account for about 15% of the global equity strategy, compared with about 50% of the portfolio three years earlier. Mr. Harvey said: “We'll need a lot more convincing ... before we start buying (emerging markets) again.”

Data Editor Timothy Pollard contributed to this article.