When reports surfaced in July that $680 million in funds apparently linked to state-owned 1Malaysia Development Berhad had ended up in Prime Minister Najib Razak’s bank accounts, escalating a scandal surrounding the sovereign wealth fund, foreign investors were quick to sell Malaysian stocks, analysts and fund managers say. A funny thing happened in the market, though. Stock prices on Bursa Malaysia held up relatively well, despite speculation about a potential political crisis and a sharp drop in the Malaysian ringgit.
What happened? Local institutions — including Malaysian pension funds, insurance companies and mutual funds — were quietly buying on dips even as global portfolio managers were rushing to the door, investors and analysts say. “What’s been happening in Malaysia is a good example of why, increasingly, many of the markets in a region where domestic institutions are a growing force have fared much better,” says Herald van der Linde, chief Asia-Pacific equity strategist at HSBC Holdings in Hong Kong.
Outside of Japan, most stock markets in Asia have traditionally been dominated by either foreign institutional investor flows or speculative short-term trading by local retail investors. Domestic institutional investors have tended to be marginal players. That picture is changing, though, thanks to the spectacular growth of the region’s local pension fund industry and a trend among middle-class investors in the region to put more of their money to work in local equity mutual funds. “Fifteen years ago, foreigners were more dominant in markets like Malaysia or Thailand than they are now,” says van der Linde, a veteran strategist who goes by the monicker “the Flying Dutchman.”
From its May peak to late August, the benchmark Kuala Lumpur Composite index fell 17 percent, whereas the ringgit fell 24 percent as a result of capital flight by foreigners.
Things were very different in the past. In the aftermath of the 1997 Asian financial crisis, when Malaysia imposed capital controls rather than accept a bailout from the International Monetary Fund, there were no domestic institutions with the capacity to step in and support the market when foreigners fled. Stocks fell more than 50 percent from their peak levels during the crisis. “Local retail investors were panicking and selling at the time, foreigners were selling, and domestic institutions just were big enough to help support prices,” recalls van der Linde. “Now there seems to be a floor, because there are local institutions with cash that are willing buy cheap stocks.”
Domestic institutional assets in Asia ex-Japan have grown at an annual rate of about 15 percent in recent years and total about $8 trillion, according to analysts at HSBC. China, Taiwan and South Korea, the biggest markets, account for roughly two thirds of all assets; Malaysia, Singapore and Korea have enjoyed the fastest growth, with assets expanding by more than 20 percent a year over the past three years.
What’s driving this growth? For one thing, Asians who traditionally invested the bulk of their net worth in illiquid assets such as property or land are increasingly diversifying their wealth into financial assets. The development of stronger social safety nets by governments encourages individuals to take greater risks with their savings. The low-interest-rate environment of recent years has also prompted many investors to take money out of low-yielding bank deposits and put it into financial assets like mutual funds. In Singapore, income funds and high-yielding real estate investment trusts have been big beneficiaries of this trend, whereas in Korea, Malaysia and Thailand, equity-linked insurance policies are growing in popularity.
The development of local pension funds is also driving the growth. Jerome Booth, co-founder of the London-based emerging-markets investment manager Ashmore Group and author of the 2014 book Emerging Markets in an Upside Down World, who now invests in emerging markets through his own company, New Sparta, says the rise of domestic institutions is just the next phase in the evolution of Asian markets. “It’s not just Asian pension funds; it’s also local sovereign wealth funds, and of course the money from the reserves, because many of these countries have been running surpluses,” he says. “The money within these countries is a great stabilizer, and will become an even greater stabilizer.”
“Twenty-five years ago, funds like ours were the only institutions investing in Asian companies,” says Mark Mobius, chairman of Templeton Emerging Markets Group, who has invested in region’s markets for nearly three decades. “Corporate governance was weak because family-controlled companies had never dealt with minority shareholders,” he notes. “Now there are large local institutions, some of them state-owned funds, so managements take institutional investors more seriously.”
Singapore, Malaysia, Korea and Hong Kong have mandatory national provident fund schemes by which employees and employers pay 5 to 20 percent of salaries every month with a cap on maximum contributions. Other countries such as Indonesia, the Philippines and Thailand have been broadening their own national pension fund schemes to mimic Singapore’s and Malaysia’s, which are regarded as the region’s leaders.
National pension funds have a growing stream of contributions to invest, and governments have been tweaking policies to push the traditionally conservative funds, which have invested heavily in bonds, to buy more risk assets like equities. Japan’s giant $1.15 trillion Government Pension Investment Fund (GPIF) has been the most prominent regional player to increase its equity allocation, but others are moving in a similar direction.
Korea’s National Pension Service, which manages $430 billion, has increased its equity allocation to 18 percent, from 8 percent in 2003, and plans to reach 20 percent by the end of 2016. China recently allowed its local authority pension funds, which manage some 2 trillion yuan ($313 billion), to invest up to 30 percent of their assets in domestic equities. And India’s Employees’ Provident Fund Organization, the country’s largest public pension fund, began investing in equities this summer and plans to boost its stock allocation to 5 percent within one year and 15 percent within five years.
“You can’t collect a billion dollars of pension contributions and invest it all in bonds or real estate,” says van der Linde. “Irrespective of how low or how high the equity portion of the pension funds’ portfolio, the demographics in Asia are such that you are getting more money every month, and it has to be deployed in equities to get better returns.”
Korea’s National Pension Service has $2 billion in monthly contributions to put to work, mostly in equities. In Malaysia, the state-controlled Employees Provident Fund (EPF) collects about $1.5 billion every month and invests roughly 40 percent of that in domestic equities. Other funds such as the public service pension fund, known by its Malaysian acronym, KWAP, and the Armed Forces pension fund, LTAT, have monthly inflows worth hundreds of millions more.
The Malaysian market has been driven by large local institutions like EPF since the Asian financial crisis, says Sharat Shroff, a portfolio manager for Matthews International Capital Management in San Francisco. Domestic investors own more than 85 percent of the free float in Malaysian stocks, compared with 50 percent for domestic investors in Indonesia and 70 percent in Taiwan, according to data from regional exchanges.
Insurance companies are experiencing similar growth. Industry assets have been growing at annual rates of 15 to 20 percent in Indonesia, Malaysia, the Philippines and Thailand, and at rate in the low- to mid-single digits in more mature markets such as Hong Kong, Singapore and Taiwan, according to analysts at HSBC.
The rise of domestic institutional investors has reduced Asian markets’ correlation with global markets, analysts say. Booth points to the stability of the Indian stock market this summer at a time when speculation about a possible September U.S. rate hike put pressure on many emerging markets. “Volatility has been dramatically reduced in Asia,” says Booth. “That’s not because global investors are shunning Asian and emerging markets and returning to developed markets,” he adds, “but because domestic pension funds, insurance companies and mutual funds are pouring more money into local equities.”
The steadiness of the Malaysian market amid the revelations about the scandal at 1Malaysia Development Berhad was also instructive, says van der Linde. “Sure, there are still sellers who panic and want to get out, but there are now plenty of buyers as well, and that reduces volatility,” he says, adding that domestic funds also provide more depth to the market by buying more small and mid-cap stocks, whereas foreign investors tend to focus on large caps. “When you have institutions buying small and medium-cap stocks, the market is better insulated,” he contends. Van der Linde predicts that Asian institutions will drive a rerating of small and mid-cap stocks over the next five years.
Over time, more Asian institutions are likely to go the way of Japan’s GPIF, which has been playing a more active role by demanding that companies have more independent boards and use spare cash to pay larger dividends or buy back shares. “When foreign investors come in and have small stakes and make demands, companies tend to ignore them,” Mobius says. “But when a huge local pension fund demands something, companies sit up and take heed.”