Emerging Markets: Keeping faith in uncertain territories
For the last six years the £800m ($1.27bn) Devon County Council Pension Fund has been managed 75% in-house and 25% by PDFM.
The in-house portfolio started as a low cost, global consensus index fund designed to give consistently average performance. PDFM provides the added value.
In 1993 the fund was offered the chance to invest £10m in an emerging markets investment trust that was being restructured. This clearly did not fit in with current investment policy but it looked a good opportunity to get substantial exposure to some exciting new markets at the right price. The idea was put to the Council's investment sub-committee on the basis that the developed markets had performed very well during the 1980s but that in the new era of low inflation and moderate growth, they were less likely to in the 1990s. In contrast, the emerging markets could expect much faster growth which would lead to better investment returns for some time to come. Whilst individual emerging markets are high risk, a global portfolio of 20+ such markets which had a low correlation to the developed markets and to each other was not expected to increase the volatility of the in-house core fund unduly. The investment was approv-ed and performed extremely well.
Having taken the initial step and seen almost instant success, the Council has gradually increased its exposure to the sector through 3% to 5% and up to the present 8% of the fund (over £60m). This may sound a lot higher than the average fund but the decision was taken early on to sell the fund's indexed portfolio of stocks in the Pacific area because of duplication (in Hong Kong, Singapore and Mal-aysia). The average fund has at least 4.5% in this area.
Because we do not have the necessary expertise in-house to select individual countries or stocks in the emerging markets sector, all the investments are in pooled vehicles, mainly global but some regional (eg Latin America), the managers are then responsible for asset allocation and stock selection decisions. No single country funds are held.
Many of the holdings are, like the initial one, in investment trusts. These often offer the chance to buy in at a discount to the value of the underlying assets. Although quoted on the London Stock Exchange, these trusts can be quite illiquid at times and as the allocation to the sector has increased it has been necessary to look at other vehicles such as US and other off-shore emerging market funds.
One exception to the principle of letting the experts choose the stocks and the markets is a substantial investment in an index-tracking fund with equal weights in each of 25 markets. Arguably the smaller, even less developed markets offer the potential for even better returns. Having the same amount in Zimbabwe and Colombia as in Mexico and South Africa should pay dividends. The evidence to date suggests it does. Rebalancing back to equal weights is generally done when a market outperforms by over 25%. Profits are then locked in.
The last 3-4 years since our first excursion into emerging markets have confirmed some of our expectations but not others. They are very volatile and susceptible to political upsets (as expected). Although some markets have performed extremely well recently (eg Hungary) others have not (eg Thailand) and, as a sector, it has not outperformed the US and UK markets, which have continued to achieve new highs. The Mexican crisis cast doubt on the low correlation between emerging markets as the fall out was felt even in Asia, and the current nervousness over a likely interest rate rise in the US suggests that quite a few emerging markets in South America and Asia may eventually fall along with Wall Street.
Despite their not having entirely lived up to expectations the Council is still wedded to the idea that emerging markets will outperform in the long term. The US and European markets have had a very good run and may well soon run out of steam. The underdeveloped countries have the potential to continue growing fast and should eventually yield superior returns. Ian Faulkner is an investment manager for the Devon County Council