When the MSCI Emerging Market index was launched in 1988 it represented just 1.0% of the MSCI All Countries World Index (ACWI). By end 2011, it had risen to 12.6% calculated on a free float basis whilst on a full capitalisation basis, emerging markets would account for over 20%. On a GDP basis, emerging markets may represent 50% or so of global GDP. Yet for most institutional investors, allocations to emerging markets within their global equity portfolios are probably still sub 10%. Even the most sophisticated investors can still be on that journey towards higher emerging market allocations.
In a paper# in March this year, Campbell R. Harvey, an Investment Strategy Advisor at Man Group recommended that Norway’s Government Pension Fund - Global benchmark should move from its underweight position of 10.5% of its equity portfolio in emerging markets to a position of 16%: “While emerging markets are riskier than developed markets, they offer higher expected returns to compensate for that risk. While the diversification appeal of emerging markets has decreased as these markets become more closely linked to the world economy, I find no reason to strategically underweight these markets.”
Boosting allocations Most institutional investors’ allocations to emerging markets are not that significant and are underweight to the index weightings,” says Stuart Gray, Senior Investment Consultant at Towers Watson. “We are encouraging our clients to increase their weights to emerging market equities, debt and currencies.”
Deb Clarke, Head of Global Equities Boutique, concurs, and while many of Mercer’s clients generally still have allocations below 10%, Mercer believes their core position should be closer to 20% and over time could see clients having as much as 30%. Mercer’s approach to constructing global equity portfolios is based around a generalised ideal of a core unconstrained global equity portfolio with satellites consisting of high beta emerging markets and global small cap offset by a low volatility global equity strategy. “The portfolio has to be tailor made for each client and adjusted according to their own beliefs and corporate governance structures in place.”
But both perceptions of emerging markets and the reality are in a state of flux. Global equity managers that incorporate emerging markets within their overall strategy in an integrated investment process would argue, as George Greig, Global Strategist at William Blair & Co. does, that there has been a broad global convergence of economic activities, standards of management, governance and so on and hence valuations. This suggests that an integrated approach to investing in emerging markets within a global equity portfolio may be attractive. But as Clarke points out, global equity portfolios tend to focus on large cap EM stocks. The EM indices are dominated by global companies such as Petrobas which do get picked up by global fund managers. “How do you get domestic emerging market exposures with the large global emerging market companies? Is Petrobas really an emerging market stock?” asks Clarke adding: “We would like a separate EM exposure to be more domestically biased. I don’t think many global fund managers can get into small cap emerging market stocks - the local domestic companies.”
Extending into emerging markets For global fund managers, there is a powerful rationale for extending their capabilities to incorporate emerging markets as Greig explains: “We have seen some very basic developmental models evolve out of the political systems in emerging markets. Twenty years ago in emerging markets, a process of reform began, controlling inflation, reducing the impact of subsidies and other sorts of social market policies, deregulating and lowering the tax burden on businesses and freeing trade. Over time, that stimulated growth and enhanced profitability. That process led to a convergence of corporate performance as well.”
The story of the 2000s was that emerging markets attracted a lot of assets because they were converging to global standards. In addition they increased their share of global market equity capitalisation: “I think that process has come to an end. The valuations of emerging market companies and developed market companies within the same sectors are comparable and in some sectors such as healthcare and consumer staples, emerging market companies are often trading at a premium,” Grieg says.
Gerald Smith, Head of the Global Opportunities strategy at Baillie Gifford, also makes the point that while a key driver behind emerging market investment is accessing the fast growing domestic consumers, emerging markets now account for an increasing proportion of sales for developed market companies. These developments have led to the relative performance patterns between emerging and global ex-emerging equities becoming more complex since the 2008 market crash: not only is correlation going up, emerging markets also seem to be losing some of their high-beta characteristics.
Index weightings For those schemes who are looking to match or exceed the MSCI weighting in emerging markets to capture long term growth there is another dilemma in that, as Kemal Ahmed, portfolio manager at Investec Asset Management points out, of the 21 countries in the MSCI EM index, seven large emerging markets account for approximately 80.0% of the index (the BRICs together with Korea, Taiwan and South Africa) with the remaining 14 smaller emerging markets receiving little dedicated investment capital. The rest of the universe of developing countries, only some of which are included in dedicated frontier market indices, are not represented at all in the ACWI benchmark leaving institutional investors with no exposure at all to some of the fastest growing economies in the world, driven by the growth of domestic consumer demand – a trend that will persist for decades to come.
The issue of accessing the domestic demand story as well as the smaller emerging and frontier markets which are rarely covered adequately by global fund managers is why institutional investors may be keen on separate emerging market mandates. “It is interesting to get exposure to companies with direct exposure to emerging market domestic growth drivers and not just dependent on index definitions,” says Gray.
Global developed market companies may have increasing emerging market exposures, but their returns are heavily dependent on factors quite outside the emerging market consumer demand story. What they can bring to emerging markets is their specific expertise applied to high growth markets, which for investors, can sometimes be captured in locally listed subsidiaries. Greig adds: “We find that in India, local subsidiaries of multi-nationals outperform local companies in terms of profitability and relative growth and they tend to outperform their parents as well.”
But accessing emerging markets via just the mainstream universe typified by the MSCI EM can leave little exposure to the domestic demand growth story that is driving emerging market economies. “Allocation to emerging markets can often be just to the larger stocks which are dominated by energy, mining, Chinese state owned enterprises and export dominated companies such as Samsung,” says Gray.
Most of these sectors are closely tied to the developing world, driving much of the correlation between emerging markets and developed. But while mainstream emerging markets may be converging with developed markets, that is not the case for the smaller emerging and frontier markets. Greig says: “Frontier markets are everything emerging markets used to be. They are inefficient, under-researched, illiquid; they don’t always work properly and can have very idiosyncratic corporate structures. They are much more intensive from a research viewpoint so William Blair does not cover them in any detail.”
Perhaps it is not surprising that Clarke says: “Provided they have the governance, I think clients would generally prefer a separate EM allocation”. Mercer have seen around 50% more searches for global emerging market equity mandates over the last couple of years: “People haven’t always had allocations to dedicated GEM before so some of these represent new mandates rather than replacing existing managers. It represents an increase in allocations to GEMs.”
But the big issue facing new investors is the capacity constraints faced by existing managers. Baillie Gifford’s own dedicated emerging market strategies are closed to new investors because of capacity constraints. So as Smith readily admits, it makes good business sense for them, like other global managers with good emerging markets capability, to leverage the assets they can raise through emerging market opportunities with limited capacity within a much larger capacity global equity portfolio. It does create more difficulties for investors looking for dedicated emerging market portfolios: “We are pleased to see managers closing although it may cause us a headache. It does mean we have to find new managers or consider moving to regional mandates; although we haven’t done much work on regional at this stage” says Clarke.
Regional strategies Regional strategies are certainly one way forward but there are problems: “Asia is very well established for regional strategies so that is why we see a lot of Asia regional mandates. But there are not as many specialist Europe, Middle East and Africa (EMEA) managers or Latin America (LatAm) It could be that these types of regional mandates are managed by more domestically focused investment houses.” says Clarke. Moreover, as she points out, for many clients emerging markets as a whole is a small exposure in their overall portfolio and the regional funds can give different types of sector biases: “Russia would be energy. LatAm would be commodities and Asia tech. We believe it is better to allow managers themselves to allocate between the regions otherwise on what basis might clients allocate?”
Investec have the view that investors with existing emerging market portfolios who seek to increase allocations should make a conscious effort to find a completion strategy rather than merely adding to existing portfolios. Their “Horizon Markets” strategy focuses on 40 smaller emerging and frontier markets: “We contend that an entire investable universe composed of smaller emerging markets (SEMs) and frontier markets (FM) exists that is under-represented, poorly understood, inadequately researched and in many cases excluded from investment” explains Ahmed.
Investec’s strategy is aimed at addressing the problem that any global equity portfolio based on an MSCI ACWI or similar benchmarks would not include many of the Horizon markets, and those that are included are only at low weights. Yet they argue that Horizon markets as a whole have an economic importance much higher than their market capitalisation would suggest: “Horizon Markets have market capitalisations that are still low relative to the size of their GDPs; the correlation among individual countries is relatively low, and the greater focus on domestic consumption means they are less susceptible to the impact of declining or negative GDP growth in the developing markets” says Ahmed explaining that their approach accesses companies focused on domestic demand in a universe of countries underpinned by healthier balance sheets, positive demographics, a rapidly growing middle class and rising urbanisation.
Institutional investors are clearly constrained by the corporate governance resources they have in their strategy towards emerging market allocations within their overall portfolios. What Towers Watson sees, explains Gray, is a definite pattern by institutional investors as they grow more experienced. The path has been to move from domestic only equity portfolios, to global developed; then to global including emerging markets at the MSCI weighting; and finally to increase emerging market weightings through the addition of specialist emerging market managers, which may include the more esoteric areas such as frontier markets. Harvey gives some good reasons why in his paper:
First, a long term investor should be able to position their portfolios to better reflect total market capitalization rather than free float. They are able to absorb the illiquidity risk and, indeed, also harvest a premium for bearing it; secondly, emerging markets are more likely to experience deviations from fundamental value. Any purely market capitalisation weighting overinvests in overvalued stocks and under-invests in undervalued stocks; and finally any global equity strategy needs to be guided by both the economics of development and the link between finance and economic growth and as Ahmed points out: “Emerging markets have seen higher GDP growth than the OECD for most of the past two decades. Within the Horizon Markets universe countries such as Indonesia, Nigeria, Vietnam, Kenya, Sri Lanka, for example, are showing annual GDP growth rates approaching 5.0% or more.”
While the performance of those emerging markets and companies heavily represented in the MSCI EM index may be converging rapidly towards the developed markets, the opportunity set is much deeper than that but requires skills that traditional global managers may not possess.