From a strategic asset allocation point of view, AustralianSuper is one of the most aggressive investors in emerging markets, particularly Asia.
About a quarter of the $43-billion fund is in international equities, and nearly half of that is in emerging markets.
Equities is the vehicle for AustralianSuper’s emerging market exposure because growth remains the reason for its allocation.
Specifically the fund wants direct consumer exposure in Asia, and to do this has looked beyond a passive approach with major indexes – such as the MSCI All Country World Index – that have greater exposure to the financial and energy sectors in emerging markets.
It’s a valid strategy to look beyond passive investing in emerging markets, particularly given the mixed performance of equity markets that make up the index, and also the dominance of state-owned enterprises.
Conrad Saldanha, managing director and portfolio manager of emerging market equity at Neuberger Berman, says benchmarks are not reflective of the underlying economy – and that is true for both developed and emerging markets. But emerging markets have a number of unique characteristics which means active management is even more of an obvious choice.
Benchmarks in emerging markets capture the dominant drivers – commodities, financials and state ownership – which in some countries such as China are 90 per cent of the benchmark.
“You get the biggest capitalisation companies but it is not necessarily representative,” he says.
Where active management rules
Managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, agrees the beta story is not working well in emerging markets.
“It is a particularly good environment for active management. When the tide is going up and all the ships are going up, or the tide is going down and all the ships are going down, then the beta story is better. But there is mixed performance of emerging markets equities. Security selection is paramount,” he says
Phil Edwards, principal at Mercer in London, agrees there are a lot of opportunities for skilled active managers in emerging markets.
“Active managers make sense because of the risk management perspective as well, so using active managers is useful for that.”
“We want to identify, evaluate and predict cash flow for those companies with a domestic focus,” he says.
He says there are good bottom-up opportunities in emerging markets, including in mid-cap companies and frontier markets.
According to Dorsey investors should consider the MSCI ACWI index as the starting point of their overall equities asset allocation, and then have manager tilts into various countries, some of which are emerging.
But he believes the tilts should be done on a security-selection basis – not on a country basis, which requires corporate and also global analysis.
“Asset allocation generally depends on the client’s objectives and their guidelines on absolute returns and relative returns. Many investors think of the question of whether to include emerging markets in a wider international equities exposure in terms of the index,” he says. “The weighting of the allocation to emerging markets is clearly centre stage. While not all emerging markets companies are stellar, neither are all developed market companies less attractive. You need to look at company selection globally.”
Finding your ideal weight
In Europe the reduction in allocations to domestic equities has seen a subsequent uptake in international allocations, including emerging markets.
Mercer’s Edwards says there has been a more global approach and funds are awarding global active equities strategies and, as part of that, emerging markets.
Among European asset owners, Mercer’s asset allocation survey shows the average allocation to emerging markets in 2013 is 5 per cent of total assets or about 10 per cent of equities, which is underweight compared to the proportion of emerging markets within the global equities universe.
The Finnish State Pension Fund, the €15.8-billion ($20.8-billion), VER is one European fund that has been quite aggressive in its emerging market allocations, and is currently overweight its strategic benchmark.
“We have had a benchmark structure for a few years where half of emerging market equity exposure is in a diversified emerging market portion and the other half is in an Asian emerging market portion. We tend to have an Asian tilt as a result of that. From time to time Russia has been a key performer for us, but performance has not been that good in the last two-to-three years so it has no special prominence in our strategy at the moment. Russia used to give us a major performance bonus but other than that there are no major country picks, but more of an Asian bias in a diversified strategy.”
Edwards is advising that funds look at increasing their allocations to emerging markets to be in line with the benchmark weight. The MSCI ACWI includes 24 developed markets and 21 emerging markets.
“Increasing to the benchmark weight seems sensible, and we suggest considering allocating above the market-cap weight,” Edwards says, advocating about 20 per cent to emerging markets.
In addition, he says there is an expanding opportunity set in frontier markets.
They have the characteristics that today’s emerging markets had in the 1980s, but there are limited capacity, risks and liquidity issues.”
Opening the world’s second largest economy
The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.
MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.
(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).
The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.
Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.
China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.
The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.
Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.
However MSCI is seeing enough change to conduct consultation on the country’s allocation.
Chin Ping Chia, managing director of MSCI (pictured right), says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion.
“We see this as a signal to expand the system and allow more investors to participate.”
In addition the high qualification criteria has been amended.
It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.
“This is a significant change and broadens the set of investors, which is a positive thing.”
China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.
“This is a positive message saying there is regulatory momentum to open the markets.”
However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.
“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.
“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?
“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”
Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.
“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”
In particular, he says, that would mean improvements in technology, corporate governance and transparency.
Yao says the government influence and management of the corporate sector has diminished over the years.
“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”
While China will continue to grow, Yao says it is still an emerging market and is very inefficient.
“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”