Usually when the $129-billion Ontario Teachers Pension Plan makes a strategic move, the rest of the investing community pays attention.
With a 15-per-cent allocation to emerging markets and a strategic plan to increase it to 20 per cent over the next couple of years, OTPP just opened an office in Hong Kong to take advantage of opportunities in Asia.
“Something like 80 per cent of the world trade in 2025 will be intra-Asia – we just have to be there,” chief executive of OTPP, Jim Leech, says.
The pension plan’s emphasis on emerging markets is indicative of a strategic philosophy being explored by many investors around the globe.
With rapid economic growth, shifting demographics, growing urbanisation and fiscal strength it is no wonder emerging markets have attracted investors’ attention.
In the Asian engine room
Australia’s largest pension fund, the $45-billion AustralianSuper, has nearly half of its international equities in emerging markets and is particularly keen on Asia, which makes up 50 per cent of its emerging markets exposure. It recently opened an office in Beijing and has a specific Asian advisory board.
AustralianSuper argues that investors must adapt their portfolios to Asia as it matures if they are to maintain and potentially grow their exposure to the future engine room of the world’s economy.
Similarly, the equities allocation of the $39-billion Finnish fund, Ilmarinen, is on an upward trend towards emerging markets, currently at 18 per cent of equities. The fund has investment people on the ground in Shanghai and is exploring whether to send a representative to South America as it intensifies its emerging markets focus.
Overweight emerging markets
From an asset allocation stance, a view on emerging markets is one of the more strategic decisions being made by investors. In fact managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, believes the allocation to emerging markets is the most significant contemporary asset allocation decision an investor can make.
“The biggest strategic asset allocation decision in my lifetime will be to overweight emerging markets,” he says.
The $22-billion New Zealand Super Fund is exploring just that, and is about a month away from finalising an investigation into whether to overweight to emerging markets.
It currently has a benchmark weighting consistent with the MSCI ACWI Investable Market Index, and head of asset allocation at NZ Super Fund, David Iverson, says the fund is looking at the growth and risk profile of emerging market equities and bonds when making decisions on overweighting.
He says the investigation is slightly different to that usually taken by funds in deciding whether to overweight, as it starts with the market view.
“The strategic asset allocation to emerging markets is a combination of market views and our view,” he says. “Most funds treat emerging markets equities and bonds separately, and then have a view inside that whether it is attractive. We start with what the market’s assessment is, which is the market-cap weighting that is already captured. Then we make a view on the market’s view and whether we have a separate view to that.”
In this way, NZ Super Fund is separating the fundamental valuations of the market, whether it has confidence in those valuations, and then assessing a manager’s ability to add value.
Emerging markets has moved from an opportunistic to a strategic viewpoint in the eyes of investors, according to Rob Drijkoningen, co-head of emerging market debt at Neuberger Berman, and one of the driving factors of that move has been the importance of emerging markets from an economic point of view.
The European Central Bank reports that the emerging economies’ share in global output has increased from less than 20 per cent in the early 1990s to more than 30 per cent now.
The equation is tilted even more in favour of emerging markets if purchasing power parity, which takes account of cost of living differences, is used. According to the International Monetary Fund’s World Economic Outlook, the share of emerging market economies in world gross domestic product will surpass 50 per cent this year on this basis.
Of course, the relative attractiveness of emerging markets is strengthened by problems in the developed world, and emerging markets tend to be in better fiscal shape now than developed markets, including a pretty good GDP-growth dynamic.
Conrad Saldanha, managing director and portfolio manager of the global equity team at Neuberger Berman, says emerging markets have lower debt-to-GDP numbers than developed markets, in fact there is a 50-basis-point differential.
“The shoe is on the other foot now,” he says. “There is a fiscal deficit and lower economic growth in developed markets.”
There has also been a fundamental shift in that domestic investors within emerging market countries are investing in their own markets.
“Hesitation by investors into emerging markets has come from a few angles. The market generally has been more short term and even institutional money has been fickle,” Saldanha says. “But now it is more stable because of the domestic investors.”
Saldanha says it pays to focus on the emerging markets that have been more consistent in their valuation premiums and volatility. That tends to be the countries that have a strong domestic institutional pension-investor base such as Chile, Mexico and Malaysia (as a result the manager is underweight Korea and Taiwan).
“Domestic investors buying in their own market is a big distinction for us,” he says.
Indexes and outperformance
One of the alluring aspects of the emerging market investment proposition has been its outperformance.
Over the 10 years to April 30, 2013 the MSCI ACWI IMI has returned 9.78 per cent. The emerging markets component, as measured by the MSCI Emerging Markets IMI, has returned 16.68 per cent in that time, while the MSCI World IMI has returned 9.37 per cent.
The $65-billion Washington State Investment Board uses the MSCI ACWI Investable Market Index, rebalancing to that index in 2007, which executive director Theresa Whitmarsh says gave the fund a “healthy dose” of emerging markets.
That index captures large, mid and small-cap representation across 24 developed and 21 emerging markets. It claims to cover 99 per cent of the global equity investment opportunity set.
While WSIB was quite early to emerging markets, because of the shift to the global index Whitmarsh says it would like the option to overweight but has been prevented by the difficulty finding managers to allocate to. With six emerging markets managers, WSIB is looking to propose to the board the prospect of passive emerging markets exposures because of this perceived barrier.
People on the ground
“We are not necessarily overweight but we would like the option,” she says. “There are problems in overweighting, including finding enough good external managers that are open.”
In selecting managers, WSIB has a preference for staff from those countries.
“We look for managers with homegrown talent and connections,” she says.
“One of the risks of emerging markets is that macroeconomics can look good, but the political risks are real. It is hard to assess that from the outside, it is so critical to have on-the-ground partners.”
Phil Edwards, principal at Mercer in London, says the broad range of risks in emerging markets, in particular the political risks, means the selection of managers needs to encompass those considerations.
“With regard to manager selection, we use similar rating criteria as for other markets, such as the manager’s ability to generate good ideas, put the portfolio together and implement it. But because of the political risks, we also look at managers that have access to senior politicians and figures in various economies, and reflect that in their portfolios,” he says.
“Emerging markets is quite heterogeneous and includes a broad mix of different economies, so we look for managers who have understanding and expertise of different regions and understand the differences between countries.”
While there is a continuing trend for investors to look at the emerging market weightings, the majority remain underweight emerging markets asset classes relative to developed markets, partly due to a bias towards historical perceptions of safety.
This is the first of a three-part series on emerging markets. The next two stories will explore the opportunity sets in emerging market debt and emerging market equities respectively.