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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 you’re still comfortable with 90 percent in the crash zone?”

Ralph Layman, Ramin Toloui and Allan ConwayMany 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 they’re 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 Ashmore’s 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. “That’s if they’re neutral, not bullish,” he says.

Julian Thompson, an emerging-markets specialist at $97 billion Threadneedle Asset Management in London, says the developed world’s 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 & Poor’s 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 Exchange’s Sensex index advanced 249 percent, São Paulo’s Bovespa gained 301 percent, and Moscow’s 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 segment’s ten-year average of 10.9. By comparison, MSCI’s 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, Connecticut–based 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 emerging-markets funds.)

Indexes such as MSCI’s 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. It’s 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 it’s been.’ It’s the same concept with the index,” he says.

Layman is doing just that with the $43 billion General Electric Pension Trust. The pension fund’s 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 fund’s 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 skepticism.”

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. “It’s 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 fund’s 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.

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