Sunil Krishnan, head of market strategy at $62-billion British Telecom Pension Scheme Management Limited (BTPS), the United Kingdom’s largest pension fund for employees of global telecoms operator BT Group, has sage advice for investors contemplating their exposure to emerging markets.
Examining the pros and cons of the asset class, Krishnan counsels caution.
Speaking at a recent National Association of Pension Funds (NAPF) Investment Strategies Conference, he says that although BTPS will increase its existing $2.7-billion emerging market allocation, split between debt and equity, it will be done with a keen eye on risk.
Beneath the fact that emerging markets have led global economic growth since the financial crisis lie deep pitfalls.
“Investors need to be clear at the start about the reasons why they are investing in emerging markets,” says Krishnan, 33, who joined BTPS from Merrill Lynch and Blackrock in a role he describes as “bringing a tactical perspective” and bridging the gap between BTPS’s long-term goals and the macro conditions across the asset classes.
The 321,474-member scheme, of which only 45,000 are active, closed to new members in 2001. According to a triennial valuation in 2011, it is 90-per-cent funded with an actuarial deficit of $6 billion, currently plugged with steady sponsor contributions.
BTPS, which pays out $3.2 billion in pension payments a year, returned 7.5 per cent in 2012 against a benchmark of 7.8 per cent.
The current asset allocation at the fund comprises fixed interest and cash (24.8 per cent), inflation-linked (21.7 per cent), property (10.5 per cent), absolute return (7.3 per cent), alternatives including commodities, hedge funds, credit opportunities and emerging market bonds (12.2 per cent). UK equities account for 5.7 per cent of assets under management and overseas equities 17.8 per cent.
The fine grain of emerging markets
At BTPS there is no presumption that emerging market equities are a door to accessing long-term economic growth in developing economies.
Economic growth doesn’t necessarily mean better returns for listed emerging market corporations: these companies could be state-owned or additional revenues could fail to turn to profit because of governance issues, says Krishnan.
Neither should investors expect emerging markets to bring diversification. Although an emerging market equity allocation improves “diversification chances”, Krishnan believes there is a stronger case for diversification in emerging market debt over equity.
One reason for this is what he calls an “arbitrary distinction” between emerging markets and developed markets, pointing out that 20 per cent of the revenues from MSCI ACWI index now come from economies including India, Brazil, Indonesia and South Africa.
“Chilean bonds are no hedge for investors in UK lenders,” he says in reference to scant evidence of the liability hedging benefits of emerging markets.
He advises against favouring particular emerging markets too. “A Peruvian copper mine is no better than the Turkish middle class.”
He points out that although the most popular emerging market theme of consumption is starting to take over from construction, equity valuations hinged on emerging markets anticipated consumer spend “don’t imply euphoria” just yet.
Where emerging markets can offer diversification is through investment across the spectrum that includes local-currency emerging market debt, mainstream emerging market equities and frontier markets too. Although frontier markets pose challenges around liquidity, “less than half of what happens in frontier markets is explained by other markets” offering real diversification benefits.
Other risks “worth monitoring” are China’s water security and the country’s ability to make the transition to a “sustainable economy,” more driven by consumption.
He flags emerging market economies that export to developed markets as particularly sensitive to demand from western economies and warns that volatility in developing markets risks forced selling, although liquidity is no longer such a problem. “You can get your money back, but you can’t get the price.” For those sacrificing liquidity for returns in emerging market private equity or infrastructure assets ensure “top dollar” for the illiquidity premium.
BTPS doesn’t hedge its emerging market currency risk.
“If you believe in an emerging market, we feel this should reflect itself in an appreciation of the currency,” he says. Although bad governance would be “an unlikely source of losses for a scheme”, he warns of the reputational damage of investing in companies hit by scandal and suggests emerging market funds use sub-custody arrangements.
Investors can access emerging markets via world equity indices, which already have emerging market revenues, and he suggests developed-market managers may be able to invest in off-benchmark emerging market opportunities.
But he also advises on active management. Not only does this ensure a keen monitoring of the risk, analysis shows emerging markets have regional winners that rotate every five years or so. “Does the bog-standard market exposure give you what you want?” he asks. “A large part of emerging markets aren’t beneficiaries of the Chinese middle class.”
Hermes manages $35 billion of the BTPS portfolio, including all the scheme’s property investments and the majority of its inflation-linked mandates. Hermes also manages a small number of active equity portfolios targeting small and medium enterprises.
The majority of BT’s UK equity allocation passively tracks the FTSE 100, managed by Legal and General. The equity portfolio includes a 4.4 per cent allocation to global large-cap, which seeks defensive exposure to global equities via exposure to 40 financially conservative companies. Elsewhere, M&G manages the majority of the scheme’s UK corporate bond portfolio and Wellington manages a new 5 per cent allocation to global investment-grade corporate bonds.
As for emerging markets, Krishnan concludes that the fact they are cheap and the return case has improved makes for a legitimate allocation. “There is nothing wrong with disagreeing with the market, but you do need to be clear from the start about the reasons for your investment.”