RIsing the EM roller coaster
It is a fallacy that the world is divided into countries that have already emerged and those that are emerging, said Roger Nightingale, economic adviser to pension funds and global strategist at Millennium Global Investments, kicking off the recent IP E-Symposium on ‘Emerging markets investing’.
“The vast majority of non-emerged countries are non-emerging,” he said. At any one time, only four to six countries were actually in the process of emerging, which showed that making the transition had to be very rare.
Nightingale asked what it was that made a country capable of deploying its extra resources into investment, and keeping them away from the wasteful consumer and government. “My guess is it’s more psychological than technical,” he said. The anxiety resulting, for example, from losing a war – as in the case of Germany and Japan – could make a population desperate to produce financial security.
Does style investing make sense in emerging markets? Erik van Dijk, CIO and partner at fiduciary advisory firm Compendeon, began answering this by pointing out that asset allocation decisions were behind most investment success or failure.
Market timing and country selection were vital with emerging markets, he said – a heterogeneous and lowly correlated group of countries. “This is really a factor that plays an important role in what we should see and have to do when investing in these markets,” he said.
Tactical asset allocation was often done in a relatively ad hoc way, contrary to asset liability modelling and strategic asset allocation. “It rarely includes style at this level,” he said.
If you wanted to include emerging markets, he said, you should have a structured allocation framework and the first step towards this is determining the appropriate risk level. The second was to pinpoint portfolio constraints, particularly the investment horizon.
Style should then be considered. Would there be tilts in terms of value versus growth or large versus small? Experience was also an important factor. “It’s extremely useful to know about yourself, … how do you react during extreme periods?” he said.
The arguments in favour of emerging markets were the excess return story, the greater universe of stocks and diversification, said independent consultant Georg Inderst, setting the first panel discussion going.
Austrian multi-employer pension fund APK Pensionskasse had had dedicated investments in emerging markets for the past three years, said Guenther Schiendl, head of investments. Among its reasons for moving into the sector was the higher yield in fixed income. There was also the view that appreciating currencies might add even more value, he said.
APK’s approach differed between fixed income and equities. “In fixed income we take the global emerging markets approach… in equities we take a regional approach,” said Schiendl. But both were actively managed.
Though risk had traditionally been seen as event risk in emerging markets – eg, a political event bringing the country down – Schiendl believed this was less and less the case as the economies matured.
Danish pension fund Industriens Pension had been in emerging markets since 1999, said Mads Peter Thomsen, portfolio manager fixed income. The fund started off in equities, but now had 10% of total assets in emerging markets – half of that in equities and half in debt. External managers were used for all portfolios.
“It’s looked as if it’s quite easy for the managers to beat our benchmark, and we’re quite happy with that,” he said.
Making a point on style, Thomsen said some managers said they got their alpha in negative markets. The fund found this unsatisfactory. “If we get our tactical asset allocation right, we should be out of the market when it’s negative, so we’ve gone to the managers that are able to perform in positive markets,” he said.
Dan Draper, country head UK at iShares, said correlation between developed and emerging markets seemed to be increasing. “However,” he said, “offsetting that are the pure rates of real GDP growth that emerging markets offer.” ATP, Denmark’s e49bn first pillar pensions giant, started investing in emerging markets in the summer of 2002, said chief fund manager Henrik Gade Jepsen.
“It was quite a volatile period, in the run up to elections in Brazil… but we thought the long-term case remained,” he said. ATP now had about €600m in the asset class – all outsourced to specialised external managers.
“Our policy is ‘don’t try this at home’; it’s an asset class that requires special skill, and we don’t have that skill in-house,” he said.
Some saw local currency debt as the next step in the maturation of emerging markets debt, said Gade Jepsen. Local currency debt exhibited even lower correlations than dollar-denominated debt, he said, and historically, risk-adjusted returns had also been good.
But returns mainly came from currency appreciation and high short-term interest rates, he said. “That means it requires a distinct skill set to manage strategies.”
In reply to a question, Gade Jepsen said it was very likely that in the future ATP would have a dedicated local currency mandate; although the fund had not given much thought as to the benchmark for such a mandate, he said it would probably be treated more like an absolute return strategy.
In the second roundtable of the day, moderator Jesper Kirstein, managing director of consultancy Kirstein Finans in Copenhagen, asked the three panellists how the investment perception of emerging markets had changed in the last few years.
Corporate scandals such Enron might have helped attitudes shift. “The notion that if you only invested in the US or Europe you’d get along fine was shattered,” said Kurt Kara, portfolio manager at FMS 04, part of LD Pensions.
“It turned out that some of the countries with the highest GDP per capita had the worst-run companies in the world,” he said. But perhaps the investment pendulum had now swung too far and some managers had forgotten the risks in emerging markets, he added.
But Gujón Ármann of pension fund Frjálsi in Iceland said his fund considered the prospects for emerging markets to be fine. “In many countries you see the new middle class, the new consumer. And these are changes that have been evolving for many years,” he said.
Magnus Backstrom, CIO at Finland’s OB Bank Group Pension Fund, said his team was reasonably optimistic about the asset class too. He pointed out, though, that emerging market debt was not the same as high-yield bonds. “We’re talking about a very diverse group of asset despite everything being labelled emerging market debt.”
In reply to a question on currency, Kara said restricting yourself to hard currency assets meant limiting opportunities. “But one should realise that expanding the opportunity set also expands the risks.” In the Danish market, said Kirstein, there had been several dedicated local currency searches. Investors were tending to think in terms of risk diversification between hard currency management and local currency management, he said.
Panellists agreed emerging markets equity prices were bound to crash sooner or later. Current high prices were simply a result of global investors pouring their money into the asset class, trying to pick up yields, said Kara. Ármann, though less bearish than Kara, said: “It’s going to be bumpy road.”
Risk premiums within emerging markets have gone down, Joseph Mariathasan, director of strategy at consultancy Stratcom, said, speaking to the symposium about the case for emerging markets equities investments.
The asset class had outperformed developed markets since the 1997 Asian crisis lows, he said, and emerging markets were now entering their sixth year of outperformance. But this was not a reason to back out now. Current valuations were not unreasonably high, he said.
There were risks, though, and he cited reversal of fund inflows, politics and the impact of slower Chinese growth. Other risks were commodity price falls, inflation, higher energy prices squeezing profit margins.
Local fund managers were no longer the only way into the asset class. “The advantages of access that many of the local fund managers have had are disappearing,” he said.
Five years ago, emerging markets behaved very differently to developed markets in terms of return potential and risk potential. “In general that huge divergence has lessened,” he said.
“We are increasingly operating in a global economy,” said Stephen Breban, CEO of City Capital Partners, “and that is one of the reasons why we should look at emerging markets private equity.”
Emerging markets were becoming increasingly consumer-orientated, he said. This was the case for both India and China, and other developing economies. “It opens up further opportunities,” he said.
India and China were the investment hotspots, he said; legislation had provided greater protection for foreign investors there. The crash of the late 1990s taught those governments a great deal, and they had reacted by reducing protectionism.
“There are a large number of companies who are looking to go global – offering a great opportunity for investors,” said Breban. Citing Bharti Telecom as an example, Breban said companies already existed in India that were much larger than could be achieved in Europe, because the market there was not fragmented. Speaking on selecting and monitoring managers for emerging markets, Scott Lothian, head of manager selection at Watson Wyatt in Hong Kong, said it was important to understand the fundamental drivers of a manager’s performance.
As with choosing managers for any other asset class, the key criteria were business, people and process, he said, but added there were a few differences when it came to selecting managers in emerging markets. “We strongly advocate the use of a specialist manager,” he said. It was particularly important to find skilled managers in emerging market debt because there was a wide dispersion between the returns of different managers. On the use of benchmarks, Lothian said Watson Wyatt preferred the more flexible absolute return approach.
With emerging markets equities, he said it was better to use a global emerging markets manager rather than several specialist local mandates. “The added benefit of a specialist doesn’t justify the added cost… of having multiple managers, for what is a reasonably small proportion of your fund,” he said.
There are currently 710 emerging markets hedge funds operating, said Rajeev Baddepudi, analyst at hedge fund research firm Eurekahedge, between them managing over $120bn of assets. Most of these followed long-short strategies, he said, but the sector was gradually developing into other strategies too. Between 2002 and 2005, asset growth had been much faster than the growth in the number of funds, he said.
“The past three years have largely seen rising markets and most of the long-only funds have done well,” he said. Increasingly there were a number of single country funds available, for example, those specialising in India, Korea or Brazil. The most significant obstacle in the region was capitalisation for start-ups, he said.
In the last roundtable of the day, experts from three pension funds with exposure to emerging markets discussed investor expectations and risk issues.
Leif Hasager, senior vice president and head of investments at Denmark’s BankPension, said he was a firm believer in emerging markets equities. The fund, which first bought into the asset class in 1994, now has 14% of assets in emerging markets equities and around 9% in emerging market debt, he said.
“I have travelled extensively in emerging markets, and have been surprised at the level of sophistication among emerging markets managers,” he said. “All in all, we have had very good experiences with emerging markets equities.”
What were the main negative issues, asked moderator Georg Inderst? The fact, said Hasager, that more established emerging markets such as Korea and Taiwan would soon leave the universe. Eastern European countries, too, would soon be gone.
“That would more or less force us to look for alternatives,” he said. Investment in countries such as Vietnam and those in Africa would not be as straightforward.
Paul Dolan of Ireland’s €2bn An Post Fund said his fund was a recent entrant to the asset class, and now had 5% in emerging markets equities. “We’re looking for opportunities and a reason to diversify from traditional equities,” he said.
Raj Thamotheram, senior adviser at the Universities Superannuation Scheme in the UK, noted that investors were in a bullish mood on the asset class. The argument used was that things were different this time, he said, but he asked – are they really?
“My sense is there’s more backing for the latter point of view,” he said. The JPMorgan index of emerging bonds was just 2% above US Treasury bonds, he pointed out. “So that’s quite a lot of risk for not much gain.” It was important to evaluate emerging markets investments thoroughly from a risk perspective, he said.
Currency crises in emerging market countries can wreak havoc, and Eric Busay, currency overlay and international fixed income portfolio manager at CalPERS, showed the impact of the Malaysian experience of 1998. That September, exchange controls were imposed that created settlement losses of between five and 10% for many investors.
“This experience ends up suggesting that over the period of time, currency hedging helped dampen the blow,” he said. But the timing of the hedge was critical to returns, he pointed out.
Another lesson to learn was that during a crisis, rules could and did change. Investors ought to have a policy in place – before a crisis happens – to help with decision making. “So that decisions can be made, and that the decisions made have a sense of guidance that is acceptable to all,” he said.
Today’s currency markets harboured many and varied risks, he said. The task for investors was to judge the size of their currency exposure relative to the size of their entire portfolio, and ask whether it was a significant risk. “Globally, we’ve seen spreads tighten considerably, and emerging markets themselves have done extremely well over the last few years,” he said. “The cycle does seem to be a little on the high side.”
Asked whether CalPERS considered currency to be an asset class, Busay said the answer depended on the hedge that was involved and the outlook for those particular markets. “CalPERS does not hedge 100% of its external investments,” he said.
“We try to determine them in terms of the overall portfolio analysis… some of the currencies have been very expensive to hedge.”
Tim Reucroft, director research at custody risk rating and advisory firm Thomas Murray, said there was a wide variation between sovereign credit ratings within emerging markets.
“You need to look in detail if you want to settle in some of these markets,” he said. “Typically, there is more than one depository in some of these countries.”