In this paper MSCI applies its framework for defining macroeconomic risk to strategic asset allocation, labelling assets as either risk premium or risk hedging. It applies the analysis to arisk-parity portfolio, showing how its relatively high exposure to inflation shocks makes it a risk premium portfolio.
To access the paper click here
The emerging market story is a puzzle with many pieces. From an overall philosophical standpoint, the demographic and economic shifts are obvious reasons to have a weighting to emerging markets. But the complexity comes into play with the question of how to invest.
Investors can consider private equity, property and other direct investments as a way of investing in emerging markets, but it is via the three main areas of debt, equities and currency that most of the action occurs.
Within fixed income there has been a recent structural shift that has implications for the way investors view the asset class, and its correlations.
Emerging market economies – a structural reduction of risk, a paper by Neuberger Berman’s Alan Dorsey, Juliana Hadas and Parth Brahmbhatt, outlines emerging-market sovereign-debt issuers have migrated to investment grade credit, which has meant that emerging market debt as an asset class has seen a reduction in its correlation to non-investment grade corporate-debt indices and an increase in its correlation to investment grade indices.
This means hard currency, or dollar-denominated emerging market debt, is trading at a much lower risk premium versus high yield than it has historically.
Secular, not cyclical
The paper outlines the possibility that this risk premium compression is secular, not cyclical.
In other words, it may be a one-time transformation in the perceived “riskiness” of the emerging debt asset class.
Co-head of Neuberger Berman’s emerging market debt team, Gorky Urquieta, says the detail of this structural transformation is seen by looking at the comparison of external debt to domestic debt in emerging markets, as well as the emerging markets compared to developed markets.
“It is clear how there is a divergence, with emerging market debt to GDP at 40 per cent and declining, while developed markets is around 100 per cent and increasing,” he says.
There has also been an increase in local demand for emerging market debt, with debt rotating from external to internal, especially in countries such as Russia and Brazil, which has contributed to economic growth and the stabilisation of debt markets.
“Emerging markets are net external creditors – they have more assets than liabilities – that provides them with a significant buffer,” he says. “The dynamics are better than in the developed world, and achieved on much higher growth rates and better management of fiscal accounts.”
Performance matters
Emerging market debt issuance is at record levels, in both issuance and dollar value, as investors seek new markets with the prospect of enhanced returns in the low interest rate environment of developed markets.
Flow data shows there has been an estimated $17 billion of inflows into emerging market debt in the year to mid-March with a bias towards emerging market local currency and emerging market corporate funds.
Dealogic, an investment banking platform, reports that in 2012 the deal value of emerging market debt issuance was close to $900 billion and for the first quarter of 2013 that was already over $300 billion.
In size, it is now comparable with the US treasury market.
At a time in which investors have been desperate to find investments with decent yields, emerging market debt was a logical choice given the robust underlying fundamentals of the asset class.
Emerging debt has seen strong performance and in the 10 years to October 31, 2012: the average annual total return was 11.34 per cent based on the JP Morgan EMI Global Diversified Index, making emerging markets the best-performing fixed income asset class in the period.
But investors around the world have typically had low allocations to the emerging market fixed income space, US investors for example have around 2 to 3 per cent in emerging markets.
“In the context of any measure, it is extremely inadequate,” Urquieta says.
Historically the concerns have been around transparency and the size of these markets which has fed ultimately into liquidity concerns.
“If there is risk-off, then emerging markets are still risk assets; there is no mechanism for sovereign defaults. And corporate recoveries are lower than in the developed world,” Urquieta says.
Yield and structural shift
But with risks there can be opportunity.
Phil Edwards, principal at Mercer in London, says emerging market debt has gone through a transformation in recent years.
He says in 2009-2010 there was interest when yields looked attractive, especially compared to developed markets, and allocations grew quite quickly.
A Mercer survey shows that 13 per cent of European funds have an allocation to emerging market debt, with the average allocation about 5 per cent of total assets.
“Even though yield has come down materially, there is still a case for investing in emerging market equities and debt,” he says. “There is a crossover element. We have seen some, but not many, investors making use of emerging market multi-asset funds. Our preference is to access specialist expertise in each space because they are different and need different skills.”
Edwards is intrigued by the “interesting characteristics” in emerging market credit.
“Funds are seeking exposure through the same emerging-market-debt mandates but broadening it to credit, expanding mandates to allow managers to go into credit.”
The €140-billion ($183-billion) Dutch fund, PGGM, has about 5 per cent of its total portfolio in emerging market local currency debt, which relatively speaking is an overweight position.
It says that while risk premiums have decreased, markets have grown, there is more liquidity, and fundamentals have improved across deficits, debt and policy.
This means that both risks and rewards have decreased, but the giant fund still says there is added value for emerging market debt in local currency because yields are still substantially above developed market yields.
Within emerging markets there has been a structural shift away from sovereign to corporate credit. On average corporates are better rated than sovereigns (see JPM index) and more than half of the assets are investment grade.
The fixed income portfolio of the $65-billion Washington State Investment Board is positioned to take advantage of the structural shift in emerging market debt.
While it doesn’t have a set allocation to emerging markets debt, it currently has about 36 per cent in emerging and frontier market debt, about half of which is in non-denominated bonds.
This is a significant overweight position compared with the Barclays Universal benchmark which is mostly developed market bonds. (Incidentally Barclays has 12 specific emerging market bond indexes).
In addition, the WSIB portfolio has a lot of corporate debt, which it started building in the mid-1990s, and executive director Theresa Whitmarsh says the team is agnostic to geography, rather it looks at macroeconomics, fundamentals and valuation, alongside its own judgement.
“Emerging markets have a great growth story, great demographics, urbanisation trends and fiscal strength. Following the Asian crisis they had to put their fiscal shops in order, and they did, and they are in good shape.”
The WSIB bond portfolio has about 70 per cent exposure to corporates overall, and within emerging markets fixed-income allocations, only two of the top 10 holdings are sovereign debt.
What will emerging markets become?
The emerging markets secular trend of improving fundamentals, has different ways to play.
Emerging markets equities is one way, currency another, risk premium on emerging markets sovereign or credit or a combination, another.
Rob Drijkoningen, co-head of emerging markets at Neuberger Berman, says that in the early 1990s investment grade was a negligible part of the index, now 56 per cent is investment grade.
“It has become less volatile and credit quality has improved,” he says.
In addition, local yield curves have developed, which could create a credit culture, leading to the need for a benchmark culture, and then the pricing of other products.
“We are seeing the establishment of local yield curves,” he says.
Head of investment strategy and risk at Neuberger Berman, Alan Dorsey, acknowledges low yields but says spreads are not at all-time lows.
“Global monetary policy created low yields, but investors still need to make money, beneficiaries still need to eat. Where do you go to get that money and provide that food?” he says.
Dorsey believes emerging market debt is still something of an inefficient asset class especially if corporates are included.
And Drijkoningen believes emerging markets corporations are under-researched and undervalued.
“The market is similar in size to US high yields, but in emerging market corporates the opportunities have a long way to go.”
“The expansion of names and size is interesting,” he says.
While most investors are still looking at emerging markets as one asset class, Urquieta believes in three to five years’ time there might be the low/high investment grade split in mandates.
“For example, in the corporate universe we will see investment grade or high yield exposures. Those types of enquiries, such as investment grade only mandates, are taking place.”
It is possible in the future that mandates will look like a best-idea investment-grade mandate across emerging markets and developed markets.
But a word of warning from Moodys says that assessments of corporate credit risk in emerging markets can also be affected by broader sovereign risk considerations, given the strong links between corporates, financial institutions and sovereigns.
This means that determining risk credits will rely more on qualitative rather than quantitative assessments.
The richest seam in the UK’s pension landscape traces the M62 corridor, a motorway that threads east to west across northern England beginning in Liverpool and taking in Manchester, Bradford and Leeds.
These cities are home to the biggest local authority pension schemes in England and custodians to a vast cluster of wealth.
“Merseyside, Tameside, West Yorkshire there is a huge amount of money in a very small space here,” enthuses Rodney Barton, director of the Bradford-based £9.9 billion ($15 billion) West Yorkshire Pension Fund which he joined four years ago from nearby schemes East Riding, and before that Merseyside.
Despite these funds proximity, each is guided by its own particular ethos. At West Yorkshire the mantra has been a bold equity strategy that it refused to pare back in the wake of the financial crisis. Now the fund is reaping the benefits of the equity lift off, returning 14 per cent in the year to March 2013.
About 67 per cent of West Yorkshire’s assets are portioned to equity in a portfolio split between the UK (36 per cent) the US and Europe (8 per cent each) Japan (4 per cent) and Asian and emerging markets (12 per cent) with the UK allocation invested only in companies with a global reach.
“We choose big companies that are not dependent on UK income,” says Barton. As the scheme taps global markets through UK equities, so it taps emerging markets – an allocation it plans to grow – through companies deriving their profits from growth in developing markets but listed elsewhere.
“We gain exposure to China through Hong Kong or Taiwan,” says Barton. “One of our primary concerns is corporate governance so we want exposure this way because we can be more certain of the accuracy of the annual report.”
Although the scheme will use unit trusts or exchange traded funds in smaller markets, the bulk of the equity portfolio is actively managed in-house.
“In markets of any size we own the stocks directly,” he says. Even the US allocation, where some pension funds have abandoned any attempt to outperform the market, is actively managed.
“Compared to other markets the US is more difficult,” he admits. “Recently we have come in below the index but not enough to worry us; long-term we are still ahead of the game.”
Equity downturn
Barton expects the equity boom to tail off, predicting total equity returns of 7 per cent over the long run.
“Years like this are nice but they won’t continue,” he says. But there is no plan to pare down the scheme’s equity allocation just yet.
An actuarial evaluation, out in nine months, will cast more light on the fund’s liability profile but until then, backed by rosy fundamentals, it is full steam ahead.
Of West Yorkshire’s 245,000 members, 91,000 still actively contribute to the fund and 81,000 have deferred benefits; the fact the scheme is 93 per cent funded, adds to the buoyant mood. It’s a small deficit that Barton attributes to a decision six years ago to ask members to contribute more.
“We were fairly aggressive in increasing our contribution rates back in 2007,” he says.
The scheme has also worked hard to cut costs, topping the list of the UK’s 89 local authority schemes in a recent report by the Local Government Pension Scheme.
“Our scheme costs each of our members just £28 ($43) a year; we have a very tight grip on out costs. One of the ways we do this is in-house management. It’s cheaper to do it yourself.”
Allocation changes
After an eight year hiatus during which the fund hasn’t allocated any fresh money to property, the scheme is now looking at boosting its 3 per cent allocation.
Assets here are currently portioned between the UK (two thirds) and Europe (one third). Similarly, West Yorkshire’s unquoted infrastructure allocation is minimal, perhaps 1 per cent, with most exposure channelled through the equity portfolio via investments in utilities like water companies, where it has “positions with big dividend payers.”
Unquoted PFI infrastructure funds sit in the 5 per cent private equity allocation. “The original PFI contracts had a much higher risk and reward and they now provide long-term index-linked cash flow and are very attractive assets for pension funds.”
The scheme hasn’t joined the government’s Pension Infrastructure Platform partly because “it wasn’t approached in the first wave and discounted the idea” but also because of the stop-start nature of the PIP’s progress to date as it struggles to find a balance between the priorities of its founder members, and the government’s desire for infrastructure investment.
Elsewhere, a 6 per cent allocation to hedge funds stood West Yorkshire in good stead during the financial crisis. Since then the allocation has disappointed however, and been shaved to 3 per cent.
“After 2007 I don’t think hedge funds saw the recovery coming. They got left behind and once you are left behind it is very difficult to catch up.”
In contrast, private equity has faired better. “Our experience with private equity has been pretty good; it’s delivered long-term 11-12 per cent returns. The bad periods have been a function of the equity market and an inability to sell anything, but pleasingly we had lots of realisations in 2011.” West Yorkshire’s most consistent private equity returns have come from small and medium-sized funds. All allocations to private equity, property and infrastructure are managed externally.
West Yorkshire has an 18 per cent allocation to bonds, a quarter of which is in corporate bonds and three quarters in government and index-linked bonds in the UK and overseas.
“We recently increased our corporate bond exposure because they have a shorter maturity and we have grown nervous around government bonds.” Most corporate bond exposure is in UK and US however. “We come across fewer opportunities at the right price to invest in European corporate bonds; companies there are much close to their banks,” he says.
Many institutional funds boast responsible investing credentials, but Switzerland’s Nest Sammelstiftung has taken the extra step of molding its investment strategy around a sustainable template.
The sustainable agenda is more than just a focus for Nest. It forms the very ethos of a fund that markets itself to potential members as “the ecological and ethical pension fund”.
Following a sustainable line to any level can be an exhaustive task, but Peter Signer, head of investments at Nest Sammelstiftung, admits that when investment strategy decisions run into debates in the sustainable sphere, an extra dimension of soul searching results.
For instance, should a sustainable investor adopt a hedge fund strategy?
Signer says that “there has been plenty of discussion as to whether we feel hedge funds are acceptable on sustainable grounds”.
It is not always a matter of simply accepting or rejecting an asset class though, and Nest’s pioneering approach has seen novel ideas being floated where the responsible investing and strategic asset interests meet.
Although it has not been able to realise it yet, Signer says there has been serious discussion of Nest Sammelstiftung launching a long-short strategy that would see it short sell the equities of companies it deems unsustainable.
If this strategy takes off it might be bad news for Swiss banking giants UBS and Credit Suisse.
The CHF 1.4 billion ($1.5 billion) Nest fund has blacklisted UBS “ever since we began our sustainable approach I think” says Signer – with perceived corporate governance shortcomings and the banking giant’s financing strategy coming under question.
While Credit Suisse “is close to rejoining our investment universe”, Nest Sammelstiftung’s ban on UBS remains on place.
Other banks are also on the blacklist with Nest tracking funding policies and in particular the financing of weaponry firms – an activity it feels violates its sustainable beliefs.
Signer makes it clear that these exclusions result from a careful sustainable policy rather than an anti-finance bias. After all, Nest invests close to CHF 5 million ($5.40 million) in London-based HSBC, while Russia’s Sberbank and China’s ICBC are both among its top-ten emerging market equity stakes.
Avoiding investing in ETFs is named by Signer as another consequence of Nest formulating its asset strategy under a sustainable gaze.
The fund shuns the index products just as it steers clear of all benchmarks – it would rather pick its own sector biases rather than have them carried into the strategy by the market.
In particular “we want to avoid investing in commodities as they are not at the top for us on sustainable reasons,” says Signer.
Ethical taste unsatisfied
Nest Sammelstiftung has taken its sustainable focus so far that its asset strategy is simply unable to keep pace in some regards.
Signer explains that its 25.7 per cent real estate holdings and 2.9 per cent private equity exposure would both be bigger positions if it was easier to invest towards its ideals in these asset classes.
The problem with real estate is that Nest is actively looking to invest in buildings with maximum energy efficiency – and there are apparently not enough ways to do that yet in its native Switzerland.
“There is not a big enough market for energy efficient buildings here so we have taken an indirect approach via funds” explains Signer. That has led it into a further stumbling block of accessing suitable funds, and ultimately “as not all real estate funds have green criteria we haven’t been able to fully implement our approach”, Signer reflects.
In the private equity space, the Nest fund has switched from investing via fund-of-funds to look for sustainable private equity funds under a managed account.
Signer is pleased that Nest has been able to use its private equity exposure to spur the development of renewable energies. It is an industry that a sustainable fund can clearly reap benefits from throughout the long investment horizons of its members.
“There have been a few problems in the European renewable energy industry and while growth isn’t linear we think there is good long-term potential”, says a convinced Signer.
Exclusion by business activity plays a part in Nest’s sustainable approach, with nuclear and weapon firms lodged on its blacklist. The fund aims for dialogue with companies that are close to falling out of its universe or alternatively are in a position to join.
While converts to the sustainable investment movement are these days free to pick and choose from a number of sustainable consultants, Nest has forged its own way to assess the myriad of companies it could invest in.
The fund co-founded the Inrate sustainable investing rating agency in 1995, a dozen years after its own foundation. Signer says that using Inrate has allowed Nest to tap into worldwide networks and bring engagement to its international equity picks. He says that sustainable scrutiny has seen Nest focusing its investment universe on merely a third of companies in the MSCI World index – a strategy which he confesses makes stock picking a difficult task.
Hard realities
No matter how sustainable its investing approach is, Nest clearly operates in the same environment as the rest of the world’s pension funds. It has made a substantial change in strategy in the past couple of years due to a background of persistent low bond yields.
Its fixed income exposure has been reduced since the start of 2011 to March 2013 from 39 per cent to 29 per cent – a figure at the very bottom of its tactical allocation range. Over the same period, equities have leapt from under 23 per cent to over 30 per cent with Signer saying “we don’t have many alternatives to equities” to mitigate fears of rising interest rates.
Nest was able to safeguard against Euro crisis fears though by reducing its government debt exposure to cover only Switzerland, Germany, the Netherlands and the UK. A new position on insurance-linked strategies is set to enter the portfolio in the second half of the year as Nest seeks further diversification, Signer adds. Other alternative approaches, like the possible long-short strategy might follow in time.
Nest Sammelstiftung’s 2012 returns of 6.31 per cent look good but perhaps unspectacular. Has it found its mission to grow its assets compromised in any way by its strictly ethical approach?
“Sustainable investing doesn’t always help returns but in the long run it will”, says Signer. Looking across the Swiss pension landscape, “our returns are higher than average but with a greater standard deviation”, he argues. Just as importantly for the staff at Nest’s headquarters, the sustainable credentials are proving a real attraction to the small and medium enterprises Nest seeks to provide pension cover for.
Hermes Ownership Principles address a simple question: What should owners expect of listed companies and what should these companies expect from their owners?
The expectations set out in this document are derived from Hermes extensive experience as an active and engaged shareholder. This experience suggests that there are a number of reasons companies fail in their primary goal of delivering long-term value. Our experience suggests there are good central management disciplines which will greatly increase the likelihood of value delivery.
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.
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.
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.
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.
“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.