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Previously epitomising debt, default and hyperinflation, emerging markets now contribute more than the US to world growth. Joseph Mariathasan investigates if they are suitably decoupled from the credit crunch to be a safe haven or is it just a commodity-led boom?

 "Emerging market equities have become a mainstream asset class, and that is really what they should be", says James Syme, head of the emerging market team at Baring Asset Management. Emerging markets as an asset class are now a bigger contributor to world economic growth than the US in terms of percentage share according to Jeff Chowdhry, head of emerging equities at F&C. "A pension fund with a long investment horizon should have a substantial allocation" says Syme. "A fundamental reason for that is that any OECD pension fund apart from in Japan will find that the emerging market currencies will be strengthening against their domestic currency. Moreover, the big run in emerging markets that we have seen since 2002 has been largely matched by an increase in earnings." Erik van Dijk (pictured above left) CEO and CIO of Compendeon also makes the point: "Sooner or later share price increases, triggered by either growing revenues and/or profits, in combination with IPOs, will narrow the gap between a market value-weighted and a GDP-weighted world equity index. So, emerging markets will be here to stay."

Christian Deseglise, global head of emerging markets business at HSBC Investments, agrees: "On several occasions in the last 20 years, they have epitomised default risk, high indebtedness and hyperinflation." The post credit crunch world and the possibility of a serious US recession have dampened some of the enthusiasm and raised many doubts as to how decoupled emerging markets really will be in that scenario.

As a result, while some institutional funds may have 20% of their portfolios in emerging markets, others may still have close to zero, afraid of the perceived risks arising from macro-economics, corporate governance and liquidity. But are these perceptions misguided? Emerging market proponents would argue very much so. The transformation of many emerging markets is a structural phenomenon that has developed a momentum of its own and is leading to an irreversible transformation of the dynamics of GDP growth and international trade in emerging markets.

As Deseglise argues: "Sensitivity to the US economy, as measured by the share of goods and services that emerging markets export to the US, has decreased. Europe has become more important and, interestingly, emerging markets are doing more business among themselves. Not only do they now export more to emerging markets than to developed markets, but domestic consumption within the bloc has grown strongly." As Syme points out: "The domestic demand story is a big one. It is important to note that increasing purchasing power plays through in energy and commodities. There is a big structural shift. The aggregate car fleet in Brazil, India and China increased by 28% last year, which creates a big increase in oil demand."

This theme of rising consumer purchasing power throughout the emerging markets is something than many fund managers are reacting to. While the impact of Chinese demand is widely discussed, the phenomenon is much wider. Devan Kaloo, (pictured right) UK head of emerging markets at Aberdeen Asset Management explains: "Our general view of emerging markets that you should always get exposure to domestic consumption. This could be by buying banks, or it could be local subsidiaries of international firms such as Unilever."

In contrast, the old story of export driven growth is proving to be less attractive. As Syme argues: "The devaluation of emerging market currencies a few years ago gave exporters a boost that has gradually eroded as currencies move to normal valuations. Emerging market exporters had a long period of undervalued currencies, limited wage growth, a strong dollar and high US consumer demand. None of these exist
anymore so we are cautious of export driven stories." As a result, except perhaps in the scenario of a severe US recession, decoupling of emerging markets appears to be a likely scenario in the event of anything less.

Corporate governance

Corporate governance is often raised as an issue in emerging markets. Dimensional Fund Advisors still excludes Russia from its global emerging market (GEM) strategy for this reason, although it does invest in China. As Kaloo also argues: "The quality of a company does not change quickly - if the management quality is found wanting, that is unlikely to change in the short term." Aberdeen's process according to Kaloo, has two hurdles that companies need to get through: quality and value. "If the quality hurdle is not passed. Then we don't go further," he continues. "Gazprom does not pass that despite being the single largest stock in the MSCI index so we have no investment in it at all."

But Syme argues that the focus on corporate governance in emerging markets is misplaced: "My own view is that corporate governance is a problem everywhere. The corporate scandals of the last 10 years have been predominantly in developed markets - Enron, WorldCom, Parmalat, Vivendi, Railtrack, which was a forced nationalisation, and even the recent problems arising from sub-prime. For Russia, part of our research is who are the owners and who are the managers and what are the risks. Politicised companies are a risk, so you need to be aware of that, but that may be reflected in the share price."

Compendeon's Van Dijk adds: "If anything, Russia has proven itself as a reliable, albeit not so transparent, financial market participant in the end. Old Soviet debts have often been paid off, irrespective of their purely legal status in the new Russia structure. And this is indicative of the Russian mindset and mentality as well. It is a typical emerging market problem: legal and governance structures are not as transparent or formal as we are used to. What you think you see is often not what you get, and that is not always negative."

What constitutes the universe

A fundamental issue with emerging markets is universe constituents and the relevance of indices. The total number of listed companies in all emerging markets is many thousands, only a small proportion of which are incorporated into the various indices. "We reckon that there are 400 quality companies in the global emerging market universe," says Kaloo. "Of the 400, we hold 200 in our various portfolios, both regional and global. So there are only 200 companies that are of good quality, but too expensive, which we monitor." In contrast, Syme explains: "As a house, Baring has a universe of around 1000 stocks, that is everything in the index plus some others, and 640 are formally scored."

The indices themselves, while still influential with many institutional investors, do have many fundamental drawbacks. The S&P/IFC index only includes 22 countries, seven of which make up 80% of the market capitalisation. Moreover, with the S&P/IFC's largest 100 companies accounting for about 50% of total market capitalisation, the typical global emerging market equity fund is heavily weighted toward the BRIC (Brazil, Russia, India and China)  countries together with South Korea and Taiwan. These portfolios tend to include mostly large cap stocks. This makes short shrift of the remaining 15 countries in the index, which also has no frontier markets exposure, and tends to produce large cap portfolios dominated by the seven largest countries. Such portfolios do not necessarily reflect the growing domestic demand driven stories in many emerging markets. They also have little exposure to the extended opportunity set offered by mid- and small-cap stocks.

The index providers have attempted to address some of the shortcomings by creating separate frontier market indices. But Slim Feriani, (pictured left) managing director of Progressive Developing Markets in London, which is currently undertaking a second fund raising for its own frontier markets fund of funds, argues: "MSCI has just 19 countries in its frontier index. Vietnam was not even in the S&P frontier index until the bubble in 2006, when the market cap went from $1bn (€649m) to $14bn within five years. It is now 4% of the benchmark compared to over 20% a year ago. We don't think frontier markets are 19-20 countries, but we think there are 100 - that is any country not in the main emerging market benchmarks. Not only the investable countries of today but also the non-investable. We have the 20 or so that MSCI and S&P include but also others."

But fund managers are also often heavily constrained by the marketing rationale inherent in adopting an index benchmark, which is often at the expense of a fundamental economic rationale. As Syme explains: "Our GEM product was created to be attractive to institutional markets. So the starting point is the MSCI index for emerging countries. Our own country allocation is a deviation from that index. I am sensitive to arguments that indices are backward looking but institutions need to know how we are investing and what the risks are. It is a difficult line for index creators. But they are cautious - there was talk of separating some of the emerging market countries prior to the Asian crisis. There is also growing evidence that Korea and Central Europe are mature markets."

Old Square Capital, a specialist emerging market equities manager of managers, has adopted a highly benchmark-agnostic view, according to managing partner, Kemal Ahmed. Its portfolio of ‘best of breed' single country and regional managers are all benchmark-agnostic. With a client base so far drawn predominantly from US endowments, it remains to be seen whether the approach will find favour among European investors.

Passive and quant approaches

One approach adopted by Dimensional Fund Advisors that has been successful is a purely passive approach but without reference to an external index. Active quantitative managers such as Axa Rosenberg are also starting to tackle emerging market equities. The market volatility of last summer caused a huge sell-off in many quantitative products, whose managers found themselves holding similar portfolios during a period of enforced deleveraging and buy-back of shorted stocks by market neutral quantitatively managed hedge funds. "Most emerging market quant managers held up relatively well during this period," counters Scott Crawshaw, head of emerging markets at Russell Investments. "This emphasises the dispersion of factors and signals that can still be utilised in the asset class. Additionally, the challenges inherent in appropriately analysing data in the asset class have acted as a barrier to entry that has prevented the space from getting over crowded."

Top-down or bottom up?

Style classifications have proved to be a useful way of looking how fund managers structure a developed market portfolio, but the same is not true of emerging markets. "We have tested the efficacy of traditional style classification in the emerging market asset class and believe that it is not applicable in its strictest sense as the asset class is, as yet, not mature enough to make such fine distinctions," adds Crawshaw. "Although managers might have a specific style orientation, the nature of the asset class prohibits clear classification."

Van Dijk also finds that this is the case: "Style in emerging markets is not yet a decisive factor differentiating between success and failure. Country selection is still dominant. However, with the ongoing development of these markets, Compendeon expects style to be more important in the future," he says. Crawshaw adds: "We do consider relative peer comparisons if managers utilise quantitative or pure bottom-up stock picking strategies, but in emerging markets we often find a wide array of fluid investment processes that cannot easily be placed in a certain category of analysis."

Emerging markets are still distinguished from developed markets by having much higher stock correlations within country indices than to global sector indices. One way that fund managers can be distinguished is the extent to which they rely on top down macro views versus bottom up stock selection. At one extreme, emerging market debt specialist Ashmore, runs equity portfolios from a fundamentally top-down approach based on macro-economic views of countries. The opposite extreme are firms like Aberdeen that see themselves as pure stock pickers.

"Markets reward companies that make money and reward shareholders," argues Kaloo. "When people focus on macroeconomics, they often find that it does not translate into the bottom line for companies. Companies may experience top line growth but that may not translate to the bottom line."

Many firms, like Baring Asset Management and Société Générale Asset Management (SGAM), have a combination of bottom up stock picking combined with top down macro views. Syme believes both contribute equally to the outperformance of his firm's GEM product. while SGAM, according to Philippe Langham, (pictured right) head of emerging markets, says 20% of its target outperformance arises from country and sector views, with the rest from stock selection. Syme, who is responsible for the construction of the Baring GEM product explains: "We don't score stocks; we don't second-guess our regional teams. We do top down analysis, portfolio construction and so on. We source ideas from the regional products. The history of this is that the regional products were impressive but the GEM was not, so three years ago the firm linked the regional products with the GEM."

Given the high correlation of stocks to the local country index, proponents of macro-analysis would argue that it can add value. "We look at countries through five different areas: growth, liquidity, currency outlook, politics and policies, and market valuation," says Syme. "We score each of these for the 22 countries we look at and then arrive at an overall view. We are quite focussed on current accounts as a guide to currency and interest rates and also the sectoral make-up of the market. We are negative on countries with technology and consumer discretionary and positive on countries with energy and materials." Both Baring and SocGen are currently overweight China, Russia, and Arab markets and Brazil and underweight Korea, Indian, and South Africa but while Baring is underweight Mexico, SocGen is slightly overweight.

Frontier funds

The guru of emerging market investing, Mark Mobius, managing director of Templeton, said recently that so-called frontier markets have been overlooked, and he plans to invest a fifth of his fund's emerging markets assets in the Middle East, North Africa and Central Asia in the next three to five years. Old Square Capital has about a third of its GEM product in frontier funds as well as having a dedicated frontier fund. Langham is also more bullish on frontier markets, although as he explains: "For most emerging market managers, 1-2% would be in frontier funds. We are bullish so have 4-5%. The return on equity for emerging markets is generally to developed markets at 16% pa but the MSCI frontier markets index shows a return on equity of 18%."

But perhaps of greatest attraction to many managers is that frontier markets have a lack of correlation to global equity markets generally and as a result, provide a natural hedge and source of diversification for emerging market strategies, although as Langham reiterates: "Geographic diversification is crucial in frontier markets as any one country is susceptible to a downturn." But Syme says the problem with frontier markets is liquidity: "The markets are also driven by fads so they can go off a lot when money is pulled out so that can be nasty." As a result, Feriani argues: "Putting 2% will be a problem for large fund managers such as JPMorgan, Aberdeen, Templeton and so on with $40-50bn under management in emerging markets, including emerging Asia. To be fair to their client base, they would need to allocate capacity to all their funds, but 1% may be $500m whilst a market like Tunisia has a total capitalisation of just $4bn and the free float available to foreign investors is around a quarter of that. The large funds cannot have positions for all their mandates if they tried so they have to just start with the markets and companies that are the biggest and most liquid."

Multi-manager approaches

A recent research report by Oliver Wyman commissioned by Nomura Asset Management (Emerging Markets Product Analysis, February 2008) the firm found that of the nearly 200 global emerging market funds examined, 72%  underperformed the MSCI Emerging Markets index over a seven-year period. For institutional investors seeking to raise their weighting to emerging markets substantially, the situation is even more dire as the historically best performing GEM managers are often closed to new business, or in some cases should be even if they are not. With the huge increase in demand for GEM products, it is fairly clear that many previously successful managers have gone down the route of asset gathering at the expense of performance in markets that can be heavily capacity constrained with the inevitable degradation in returns.

In contrast, single country and regional strategies have a narrower base of demand so there are many top tier single country and regional managers that have capacity to spare. It is probably inevitable that there will be more multi-managers and fund of funds focussing on regional and single country managers. Oliver Wyman's research indicates that a composite fund, consisting of top regional managers, outperforms top global managers while achieving a significant decrease in tracking error.

Nomura, with expertise only in the Asian emerging markets, has produced a GEM product in which covers the Asia Pacific and is responsible for the overall strategy; Gartmore covers Latin America, and Charlemagne emerging Europe. Progressive has around 60 funds in its portfolio - 70% closed ended and 30% open ended. Feriani explains: "The closed ended funds are often opportunistic and bought at a discount. Open-ended are best of breed and we select a manager for his alpha skill set. You like the team, track records and so on." Old Square Capital, in contrast, is a manager of managers, and whilst Feriani seeks liquidity and would avoid managers with lock-ins that may be one or two years in illiquid frontier markets, Ahmed seeks best of breed local managers for a client base that is happy to take a long-term position with local managers enabling him to invest with managers even with lock-ins more than a year.

Russell's manager of managers product is invested in a portfolio of global fund managers to provide style diversification. Crawshaw gives a note of caution on portfolios of regional and country managers: "To simply construct portfolios consisting of regional and country products for the sake of improving capacity would be flawed. One challenge of investing in country and regional products in a multi-manager framework is the potential lack of style diversification that can be achieved using this strategy. That said, we continue to watch the space and the evolution of managers of regional mandates."

Risks

Clearly, emerging markets still have at least a perception of higher risk than developed markets. Indeed, as van Dijk explains: "In the 1980s and 1990s there was quite some interest in political risk indicators and their predictive power when used in pricing models for emerging market equities. Investors with indicators that had explanatory power benefited in the rouble and Asia crises in the 1990s. It will be a challenging research process to create value-adding indicators."

But what are the risks? "Inflation and policy tightening are the major risks," argues Syme. "Most emerging market central banks are not prepared to have interest rates below CPI. With a current account surplus, you can rely on the currency. If you don't have that, then you need policy tightening -  the business cycle still exists. On a two to three year view, will demand-led inflation come from the developing world?"

The other risk is that emerging market economies have a high-energy intensity of GDP, so very high oil price spikes will be bad for emerging Asia. "In a number of countries, local prices are controlled for oil. That shields consumers. Indonesia had a subsidy but the cost became too much, so the government had to step back" says Syme.

But perhaps of more concern to investors may be the political risks arising from the rapidly increasing prosperity of societies that may struggle with equitable distribution of wealth. As van Dijk says: "As is so often the case, increased economic prosperity translates into growing demands among the middle class to get its fair share of the pie. This could lead to political turmoil and disturbances in these nations. The biggest challenges for 2008 and beyond, therefore, lie in the political arena with the economy riding its normal wavy patterns of business cycles."

Compendeon is optimistic about the economic aspects of this new world setting, but much less enthusiastic about the actions and reactions in the political arena. As a result, Van Dijk advises investors to diversify carefully, along the lines first defined by Harry Markowitz, and pay more attention to legal and political factors than they probably used to in the past.

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