Jerome Booth, head of research at $33 billion-in-assets
Ashmore Investment Management in London, was having lunch in
Munich last month with a large German institutional investor
who was crowing about changes he had made to his portfolio.
After years of hearing Booth preach about the need to
dramatically increase exposure to emerging-markets economies,
the investor excitedly announced that he had shifted his
conservative stance and doubled his allocation to 10
percent. Unimpressed, Booth deadpanned, So youre
still comfortable with 90 percent in the crash zone?
Many institutional investors are fundamentally
rethinking their approach to emerging markets. Attracted by the
powerful growth of economies in countries such as China, India
and Brazil, investors have been putting more of their money in
these markets. The debacle in Greece, concerns about the future
of the euro and worries about debt levels in developed
countries are providing more reasons for investors to shift
their weightings. Fund managers increasingly regard emerging
markets as a core part of their portfolios rather than a
high-risk sector that they can flit into and out of tactically
in an effort to boost yield, says Allan Conway, head of
emerging-markets equities at Schroder Investment Management.
The London-based fund manager has $24 billion of its $255
billion in assets in emerging markets.
As part of this shift, many investors are setting their own
allocation targets for emerging markets and using specialist
managers with extensive footprints in these regions to build up
positions, instead of leaving the job in the hands of
generalist global managers. Larger institutions are expanding
their direct presence in emerging markets while others are
using exchange-traded funds as a low-cost means of increasing
their exposure. Investors are diversifying within the
emerging-markets space, moving beyond basic equities to put
their money in fixed-income securities, private equity and
infrastructure investments. And theyre moving further
afield into frontier markets in places like Africa, seeking
higher returns. According to a survey of large, mostly U.S.
institutional investors published by Bank of America Merrill
Lynch late last year, emerging-markets equities are the most
desirable asset class, with 42 percent of respondents planning
to add to their positions over the next 12 months. By contrast,
39 percent said they were planning to reduce their exposure to
large-cap U.S. equities during the same period.
Yet for all of the recent changes, most U.S. and European
investors are still woefully underweight in their
emerging-markets holdings. People understand the emerging
markets are a big opportunity, says Richard Titherington,
CIO and head of the emerging-markets equity team at $1.2
trillion-in-assets JPMorgan Asset Management in London.
But the average pension fund thinks it is overweight at 5
percent. They need to dramatically rethink that and go to 20
percent. According to the BofA Merrill Lynch survey, U.S.
institutional investors allocations to emerging-markets
equities range from 2 to 15 percent and average between 3 and 5
percent. The $50.1 billion Virginia Retirement System has a
weighting of 5 percent, the $22.9 billion Connecticut
Retirement Plans and Trust Funds has 4 percent, and Boeing
Co.s $71 billion defined benefit plan has 2 percent.
Emerging markets constitute 13 percent of the MSCI all
country world index, so by that measure, most Western
institutional investors are indeed underweight. But some
analysts regard the MSCI weighting as excessively low. The
index firm bases its weightings on the free float of shares in
a given market; many emerging-markets companies have only a
modest percentage of their shares in public hands, with the
bulk still held by controlling families or governments.
Why should the somewhat arbitrary and fairly static rules
of an index provider define useful investment
allocations? asks Ashmores Booth. He contends that
investors should have a 50 percent exposure, which equals the
emerging markets share of global economic output based on
purchasing-power parity. Thats if theyre
neutral, not bullish, he says.
Julian Thompson, an emerging-markets specialist at $97
billion Threadneedle Asset Management in London, says the
developed worlds underfunded pension plans, trying to
operate in countries with aging populations, need to take
advantage of the growth that young people with rising incomes
in the emerging world will provide.
Anyone who had a big position in emerging-markets stocks
should have enjoyed strong performance in recent years. The
MSCI emerging markets index produced annualized returns of 7.61
percent over the ten years through June 1, compared with an
annual average return of 1.26 percent for the Standard
& Poors 500 index over the same period. Some
individual markets produced spectacular returns. Among the
so-called BRIC countries, for instance, the Shanghai Stock
Exchange composite index rose 133 percent from 2000 through
2009, the Bombay Stock Exchanges Sensex index advanced
249 percent, São Paulos Bovespa gained 301
percent, and Moscows RTS index surged 863 percent. Even
in more-recent periods, when developed markets have bounced
back strongly, most emerging markets have done even better. The
MSCI emerging markets index returned 53.91 percent in the 12
months ended April 30, compared with a 38.84 percent return for
the S&P 500.
Can emerging markets continue to outperform? Although some
investors worry about the risk of a setback after such gains,
current valuations are not excessive. The emerging-markets
segment of the MSCI all country world index was trading last
month on a 12-month forward earnings multiple of about 11.2,
slightly above that segments ten-year average of 10.9. By
comparison, MSCIs developed markets were trading at an
earnings multiple of 12.9, below their ten-year average of 16.
Emerging markets are not worryingly expensive or bubbly,
but they are closer to fair value, says Kevin Gardiner,
head of investment strategy for Europe, the Middle East and
Africa at $241 billion-in-assets Barclays Wealth in London.
One of the more aggressive emerging-markets investors is
Ralph Layman, CIO of public equities at GE Asset Management, a
Stamford, Connecticutbased outfit that manages $120
billion in assets for General Electric Co.s pension fund,
GE-affiliated insurance companies and third parties. Layman
began looking at the sector in the 1980s, when he was a
portfolio manager at Templeton, Galbraith & Hansberger and
Sir John Templeton and Thomas Hansberger asked him to research
the feasibility of investing in emerging markets. (Templeton
ended up hiring Mark Mobius in 1987 to manage one of the first
Indexes such as MSCIs may reflect the current share of
the global equity market that publicly available
emerging-markets stocks represent, but Layman contends that
they almost certainly understate the share that these markets
will have in the future. Its that future weighting that
investors should anticipate, he explains, using a hockey
metaphor. Like Wayne Gretzky said, You skate to
where the puck is going, not where its been.
Its the same concept with the index, he says.
Layman is doing just that with the $43 billion General
Electric Pension Trust. The pension funds combined
allocation to China and India is roughly halfway between the
countries 25 percent weighting in the MSCI emerging
markets index and their 68 percent weighting in a customized
model designed by Layman that includes shares held by
governments and local shares, such as Chinese A shares, that
are not available to most foreign investors. GE is also in the
process of eliminating the pension funds home-country
bias by shifting toward an equal weighting of U.S. and non-U.S.
equities in its portfolio. Our thought process on asset
allocation is fairly unique, Layman says. In
presenting it to some peer groups, there was a high degree of
GE is also building up its staff in emerging markets to
better identify the local companies that will benefit from the
growth of domestic consumption in these economies. The firm has
recently taken on new investment professionals in Shanghai and
Singapore, is opening an office in Brazil and is considering
opening one in India. We see the developed world as
needing to save more and consume less, Layman says.
Its the opposite in the emerging markets. As
consumers start to consume more, whether in health care,
education or retail, regional and localized services will be
great growth vehicles.
Goldman Sachs Asset Management is pursuing a similar
strategy. The firm, which manages $840 billion, has tripled the
number of investment professionals it has in emerging markets,
to 30, and has opened offices in Brazil, China and India.
In the next 20 years, Goldman believes, some 2 billion
people in the emerging markets will cross the income threshold
of $5,000 a year, the point at which people begin to buy
discretionary consumer goods such as mobile phones. Even
if it ends up being half that at 1 billion people, the impact
is enormous, says Donald Gervais, global head of
fundamental equity product management at GSAM in New York.
The Universities Superannuation Scheme, which manages
£29.9 billion ($43.4 billion) in pension fund money for
U.K. university employees, has added three emerging-markets
specialists to its team and aims to raise its allocation to
emerging markets to 7.5 percent from 5 percent by the end of
this year, with emerging-markets equities reaching 12 percent
of the funds overall equity position. Previously, USS put
roughly half of its equity holdings in the U.K. and invested in
emerging-markets equities only on a capitalization-weighted
basis as part of its non-U.K. regional mandates.