Investors in Nordic countries show rising interest in emerging market debt as a way to take part in the emerging market story. Jan Willers reports on findings of a recent survey.
In the spring 2011 Kirstein Financial Market Research conducted a study for Aberdeen Asset Management on emerging market debt (EMD). The purpose of the survey was to identify the latest trends within EMD investments and to understand the role of EMD in the Nordic investors' portfolios.
The study encompassed 50 end investors, 40 of whom answered our questionnaire. In addition to the data obtained from the questionnaires, qualitative data was obtained through interviews with selected investors.
Room for a pick-up in allocation
The average allocation to emerging markets debt among the investors surveyed in the Nordic region is close to 4% of the total portfolio. Emerging market debt (EMD) still represents a small part of the fixed-income portfolio, whereas emerging market equities is a more integrated part of the investors' portfolio. The largest allocation to EMD is to be found among the two fixed-income countries Denmark and Finland.
More than 40% of the Nordic investors expect to increase their allocation to EMD in the future, not least in Sweden and Norway, where investors currently have the lowest allocation. Three out of four investors in Sweden expect to increase their allocation to EMD. The majority of the investors with a relatively high allocation to EMD do not expect any change in allocation. However, this does not mean that it is a static market - investors will continue to pursue new investment ideas within emerging markets investments.
In general, investors indicated that improved emerging market fundamentals would make them more interested in EMD. When comparing fundamentals of emerging markets with developed markets, investors rate emerging markets better on growth and financial balances, which corresponds to the general market consensus following the financial turmoil, where the fundamentals of emerging markets are generally considered to be stronger. Investors believe in the emerging markets ‘story' and wish to expose themselves to emerging markets via EMD.
For most investors, investments in emerging markets are associated with increased risk. Investors who are not invested in EMD tend to consider the risk to be significantly higher than investors who are already invested in this asset class. Explaining and understanding the risk element will thus be crucial in expanding the investor base for EMD.
Figure 1 shows how investors assess the level of risk of different factors (1 = very low risk and 5 = very high risk).
Investors that are invested in EMD find that inflation and political instability are the most risky factors.
Liquidity is considered to be the third most risky factor. Investors that are familiar with EMD investments tend to be less concerned about the risk embedded in this asset class. However, many investors voiced their concern about Solvency II and the likely impact it will have on EMD investments.
Perceived risk dictates investment appetite
Risk management of emerging markets debt is primarily done via geographical diversification to avoid macroeconomic risk with each country. Additionally, investors seek diversification via different asset managers Investors with a relatively high allocation to EMD in particular use both kinds of risk management tools. Furthermore, investors aim at a relatively short duration. Many investors indicated the expected duration of EMD investments to be 3-5 years, which corresponds with the duration of the common benchmarks.
Appetite for new products
Hard currency is the first step into EMD and still attracts some attention. However, several investors are already taking ‘the next step' - allocating money to dedicated local currency mandates. Corporate debt is beginning to attract serious attention from some investors, especially the more sophisticated ones. Overall, many investors feel that emerging market corporate bonds can offer attractive performance although it is offset by less attractive risk and liquidity features.
Clear preferences for pure EMD mandates and active management
Investor opinions are very uniform when it comes to investment vehicles and management style. A pure EMD mandate with a global approach is, by far, the preferred investment vehicle among Nordic investors. The majority of the investors will have a strategic approach to EMD investment and are comfortable with dedicated mandates. Investors also have a clear preference for an active fundamental management style in EMD mandates.
Figure 2 shows which investment vehicles investors prefer to use when investing in emerging markets debt (1 = no preference and 5 = high preference).
Global EMD portfolios will leave the allocation between regions and countries to the asset manager and the majority of investors prefer this set-up. Broader portfolios are not that common, although some developed portfolios are allowed to invest in emerging markets. Recently, we have seen some examples of broader portfolios from investors including EMD as well as high yield. The preference for regional or country-specific allocations is relatively low, although some investors will supplement their global portfolio with specific country investments.
Several factors are important for investors when selecting an asset manager for EMD. Track record, historical capabilities within EMD and team of analyst are seen as the most significant factors, whereas brand name is less important. Additionally, management fees are considered important, especially with the increased focus and transparency on cost related to investment and asset management. Focus on costs is always an issue, although investors are generally willing to pay for quality.
Jan Willers is head of financial research at Kirstein Finans in Copenhagen