The convergence of emerging and developed markets argues for integrated global portfolios. But Joseph Mariathasan finds that investors taking this approach could miss out on the best opportunities
Steve Barker, managing director in investment consultancy Barker Tatham, has “a big problem” with the idea that allocation to markets should be made on the basis of their market capitalisation.
“Allocations to markets should be driven by what you hope to get out of them,” he suggests.
That sounds obvious. And yet the statement is particularly relevant to the question of how emerging markets should be included in an institutional allocation to global equities. When the MSCI Emerging Markets (EM) index was launched in 1988, it represented just 1% of the MSCI All Countries World index (ACWI). By end 2011, it had risen to 12.6% on a free-float basis. But on a full-capitalisation basis, emerging markets would account for over 20%. Yet many institutional investors are still very underweight emerging markets compared even with this current MSCI weighting.
“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.”
Even the most sophisticated investors can still be on that journey towards higher emerging market allocations. In a March 2012 paper, Campbell Harvey, an investment strategy adviser at MAN Group, recommended that the Norwegian Government Pension Fund’s benchmark should move from 10.5% of equities in emerging markets to 16%. “While emerging markets are riskier than developed markets, they offer higher expected returns to compensate for that risk,” he wrote. “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.”
For those funds that are looking to match or exceed the MSCI weighting in emerging markets to capture long-term growth there is another dilemma: of the 21 constituent countries, seven large ones account for approximately 80% of the MSCI EM index (the BRICs, Korea, Taiwan and South Africa). 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 nothing allocated to companies based in some of the fastest-growing – and least globally-exposed – economies in the world.
Institutional investors’ strategies for emerging markets generally reflect a combination of both internal governance and the gap between their perceptions of emerging markets and reality – both of which are in a state of flux.
“A lot of our schemes have only one manager for all assets, but they may be in separate funds,” explains Barker, who would typically recommend that 20-30% of an overall global equity allocation is invested in emerging markets. “Where a manager has an emerging market fund, we often use that to increase allocations.”
But global equity managers that integrate emerging markets within their overall strategy would argue, along with George Greig, global strategist at William Blair & Co, that there has been a broad global convergence of economic activity and standards of management and governance, in turn leading to convergence of valuation.
“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,” he explains. “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 of emerging markets attracting a lot of capital seeking to benefit from that convergence, which resulted in a growing share of global market capitalisation.
“I think that process has come to an end,” says Greig. “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.”
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 fast-growing domestic consumption, 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: correlation is up and emerging markets seem to be losing some of their high-beta characteristics. In the cyclical rally since June 2012, emerging markets, after many months of underperformance, offered a return merely in-line with developed markets.
A logical response might be for investors to not bother seeking dedicated emerging markets exposure anymore. And there are other arguments in favour of that approach, too. Baillie Gifford’s own dedicated emerging market strategies are closed to new investors because of capacity constraints – and it is not alone among major asset management houses taking this action. It therefore makes good business sense to leverage the assets they can raise through emerging market opportunities with limited capacity within a much larger-capacity global equity portfolio.
Are there signs of end investors following this lead? Gray at Towers Watson reports a definite pattern from institutional investors as they become more experienced. In the UK, the path has been to move from UK-only 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.
“It is interesting to get exposure to companies with direct exposure to emerging market domestic growth drivers and not just exposures that are dependent on index definitions,” he says.
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. “We find that in India, local subsidiaries of multinationals outperform local companies in terms of profitability and relative growth and they tend to outperform their parents as well,” says Greig.
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.
But while mainstream emerging markets might be converging with developed markets, that is not the case for the smaller emerging and frontier markets. Investors seeking these additional exposures face the issue of accessing the smaller emerging and frontier markets which are rarely covered adequately by fund managers.
Investec has tried to address this with what it calls a ‘Horizon Markets’ strategy focused on 40 smaller emerging and frontier markets, each underpinned by healthy balance sheets, positive demographics, rapidly growing middle classes and rising urbanisation, and hunting down companies tilted to domestic demand.
“We contend that an entire investable universe composed of smaller emerging markets and frontier markets exists that is under-represented, poorly understood, inadequately researched and, in many cases, excluded from investment,” explains portfolio manager Kemal Ahmed. “Horizon Markets have market capitalisations that are still low relative to the size of their GDPs; the correlation amongst 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.”
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 opportunities are much deeper than that but require skills that traditional global managers might not possess. There are several ways in which an emerging markets allocation can be sliced and diced into a global equity portfolio: as an integrated part of a global mandate; as a dedicated allocation next to global ex-emerging or next to global including-emerging; with or without off-benchmark or frontier markets. The right solution will probably depend as much upon governance capacity as it does upon investment beliefs.