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The New Urgency of Emerging Markets

Investors eager to gain exposure to these countries’ dynamic growth rates are expanding their allocations across multiple asset classes, moving deeper into bonds, private equity and small and midcap stocks.

Yngve Slyngstad knows all about the benefits of diversification. Recruited in the late 1990s as the first equities chief at Norges Bank Investment Management, the manager of Norway’s giant sovereign wealth fund, Slyngstad bought stocks aggressively and quickly made the fund one of the largest investors in the European market. Now CEO of NBIM, Slyngstad is looking to pursue diversification across a broader front. Last month he went to the Ministry of Finance and requested authorization to substantially increase the emerging-markets allocation of the Government Pension Fund Global, as the sovereign fund is called, because of the growing size of those countries in the global economy. The fund has roughly $50 billion of its $555 billion in assets in emerging markets or in companies heavily involved in those markets. Slyngstad wants to increase that figure by two thirds, to almost $85 billion, by the end of next year.

“We need to be part of the growth in the global economy,” he tells Institutional Investor.

Slyngstad is far from alone. Investors around the world are ramping up their commitment to emerging markets, eager to increase exposure to these dynamic economies. Emerging and developing markets are expected to grow by 6.5 percent this year, nearly three times as fast as the 2.4 percent pace of the advanced economies, according to the International Monetary Fund.

“It’s simple fundamentals,” says Joyce Chang, global head of emerging-markets and credit research at JPMorgan Chase & Co. in New York. Not only are emerging-markets economies growing faster, but in many cases their continued expansion appears more soundly based and less prone to risks than that of the advanced markets of the U.S., Europe and Japan. “EM countries continue to look better on the debt and fiscal front as developed market debt and fiscal positions have deteriorated over the last three years,” says Chang.

The emerging-markets trend has been evident for years, of course. Jim O’Neill, former chief economist of Goldman Sachs Group, now chairman of the firm’s asset management division, popularized the notion a decade ago when he coined the acronym BRIC to highlight the investment opportunities in Brazil, Russia, India and China. What distinguishes recent activity are the urgency and scale of the shift. Most Western institutional investors still have small emerging-markets allocations measured in the low single digits and are eager to increase their holdings, while more-active players such as the Norwegian sovereign fund are looking to extend their commitments. Capital flows to the emerging markets will rise to $1.09 trillion this year from $1.05 trillion in 2010, according to a forecast by the Washington-based Institute of International Finance.

For most institutions, emerging markets are becoming a core part of their portfolios rather than a niche area. “It’s time to stop differentiating between the emerging markets and the developed markets,” says Michael Conelius, portfolio manager of the Emerging Markets Bond Fund at T. Rowe Price in Baltimore. “Those asset managers who allocated 3 to 5 percent of their assets have to increase those allocations given the reality of the emerging markets. There’s a tailwind driving the markets, and for the long-term investor, the potential is enormous.”

To build up their exposure, investors are broadening the playing field. Although Brazil, Russia, India and China continue to garner the greatest attention because of their explosive growth and, in the case of Brazil, a deep capital market, more investors are moving beyond the BRIC countries into markets ranging from Colombia, Indonesia and Turkey to sub-Saharan Africa.

The new wave of investment is also taking place across multiple asset classes. Investors are increasingly looking to expand their fixed-income holdings in emerging markets. Indeed, Slyngstad identifies this area as the top priority for Norway’s sovereign fund. The extension of credit to nonbanking institutions in emerging markets, which mainly covers bond holdings, is likely to grow by 10.5 percent this year, to $273 billion, the IIF projects.

Other institutions are boosting their commitment to private equity. The University of ??Notre Dame, which has about 16 percent of its $7 billion portfolio in emerging markets, is looking to increase that weighting, possibly doubling it in the next five to seven years, with private equity accounting for half of the growth. Finding the right partners for making private equity investments “is going to be one of the most important decisions we make as CIOs over the next decade,” Notre Dame’s chief investment officer, Scott Malpass, said at a recent II fund managers’ roundtable.

As they look to broaden their emerging-markets holdings beyond the relatively modest selection of large-capitalization stocks, investors are turning in growing numbers to local money managers. “The opportunities in the emerging markets are real,” says Hiren Ved, chief investment officer for Alchemy Capital Management, a Mumbai-based money manager that focuses on small and midcap companies in India (see story above). “But as in the U.S., the dynamic growth is coming from smaller, less established entrepreneurial players.”

The intensifying focus on emerging markets is driving demand for sophisticated research in these countries. In recognition of that growing appetite, for the first time in a single issue, II is publishing rankings of the top analysts in three major markets: China, Russia and emerging Europe and the Middle East and Africa (see stories beginning on page 62).

To be sure, the growth of emerging-markets investing does face challenges. Some investors and analysts warn about the danger of lofty valuations, which in many countries exceed those in developed Western markets. Rising inflation also clouds the growth outlook as countries such as Brazil, China and India tighten monetary policy to prevent overheating. But the fundamental shift toward emerging markets remains intact despite these cyclical concerns.

Consider the latest moves by Norway’s Government Pension Fund Global. The sovereign fund maintains a roughly 60-40 split between equities and bonds in its portfolio. Emerging markets account for about 7 percent of the equity holdings, while an additional 4 to 5 percent is invested in European companies with considerable exposure to developing countries. Slyngstad wants to raise that combined exposure to 15 percent by the end of next year, assuming the Finance Ministry endorses the shift.

In addition to expanding the fund’s emerging equity allocation, Slyngstad wants to put more of that exposure in the hands of dedicated emerging-markets managers. He believes most emerging markets are less efficient than their developed world counterparts, providing an opportunity for knowledgeable local managers to generate alpha. The fund currently manages its small and midcap emerging-markets portfolio through 23 external mandates in countries that include Brazil, China, India, Indonesia, Russia, Singapore and Thailand. Slyngstad plans to increase the number of external mandates to 51. For large-cap equities, the fund treats emerging markets like developed markets, relying on stock picking by its internal managers and using exchange-traded funds to manage its exposure.

Slyngstad has more-ambitious plans for fixed income. The fund currently invests more than 90 percent of its fixed-income portfolio in the major currencies: the dollar, euro, British pound and Japanese yen. Slyngstad intends to increase the fund’s emerging-markets allocation to 15 percent of the fixed-income portfolio by the end of next year from 5 percent now. The fund eventually may invest as much as 10 to 15 percent of the bond portfolio in China alone as it shifts to basing allocations on economic growth rates rather than the capitalization of respective bond markets.

As more institutions look to emulate active emerging-markets players like the Norwegian fund, the potential for further capital flows to these economies is great. Most U.S.-based institutions still allocate only 2 to 4 percent of their portfolios to emerging markets, analysts and consultants say. Many of these investors have played emerging markets tactically rather than regarding them as core parts of their portfolios. “Buy low, then sell when the opportunity arises” is how Mary Jo Palermo, a managing director at Cambridge Associates, a Boston-based advisory firm that serves more than 900 institutional investors with total assets in excess of $2.5 trillion, puts it. “Or they would play the indexes. Often there wasn’t any more to their EM strategy than that.”

The rapid development of these economies demands a more intensive approach, analysts and investors say.

Emerging and developing countries have increased their share of international trade flows to an estimated 45 percent last year from 30 percent in 1995, according to the World Bank’s latest “Global Development Horizons,” the institution’s annual review of the world economy. These countries hold two thirds of all official foreign exchange reserves, a complete reversal of the situation a decade ago, when advanced economies had a two-thirds share. The bank projects that six major emerging economies — Brazil, China, India, Indonesia, Russia and South Korea — will collectively generate more than half of all global growth by 2025. “There are more drivers of growth than ever before,” says Hans Timmer, director of the bank’s Development Prospects Group.

The shift in economic power to the emerging markets is fostering the rise of a billion-strong middle class with explosive buying power. “You just have to spend time in these places to see it,” Notre Dame’s Malpass says. Emerging markets “will represent over 50 percent of the world’s economic growth sometime in the next ten or 15 years, and that’s a huge difference from what we saw early in our careers.”

The growth of emerging economies will transform the capital market opportunities in these countries. Developed markets currently account for $30 trillion of the estimated total $43 trillion of global equity market capitalization, Timothy Moe, chief Asia-Pacfic strategist at Goldman Sachs, estimated in a recent report. Over the next 20 years, global market cap could expand to some $145 trillion, he predicted. Although developed markets are likely to more than double in size, to $66 trillion, capitalization of the emerging markets should grow nearly sixfold, to $80 trillion, he forecast.

“The growth prospects of the emerging markets remain favorable on an absolute basis and relative to the developed markets,” says Rogerio Oliveira, head of emerging-markets trade and quantitative strategy at Morgan Stanley in New York. If investors want to optimize their portfolios, they should lift their allocation to emerging markets into the range of 20 to 30 percent, he advises. “That isn’t going to happen overnight,” Oliveira says. “But as long as the twin pillars of the long EM risk trade — favorable global growth fundamentals and ongoing capital flows to emerging markets — continue, the inflows will continue.”

Cambridge Associates also recommends that investors increase their allocations. But the firm stresses that the makeup of a portfolio is just as important as its size. In a white paper published last month titled “The Case for Diversified Emerging Markets Exposure,” Palermo and co-author Eric Winig urge institutions to adopt the same kind of multiasset approach to their emerging-markets holdings that they use for developed markets. Specifically, they recommend that investors expand their holdings into small and midcap stocks and frontier markets that aren’t well represented in the leading emerging-markets indexes, buy a wide range of sovereign and corporate bonds, and use hedge funds and private equity to enhance returns.

“Current approaches are fine as far as they go, but investors considering larger emerging market allocations — beyond 5 percent of their total portfolio — should look to generate equity-like returns and lower volatility over the long term and do more to exploit inherent inefficiencies in the emerging market universe,” Palermo and Winig suggest. “Rather than looking at pure, opportunistic beta, we now view emerging markets as deserving of a multi-asset class approach and a focus on both alpha and beta.”

Many U.S. foundations and endowments are adopting just such a strategy. The Rockefeller Foundation, like Notre Dame, is actively looking for private equity investments to increase its exposure to emerging markets, which currently represents more than 20 percent of the portfolio across all asset classes. CIO Donna Dean says she and her team are using a “combination top down–bottom up approach — finding partners, but also trying to be selective about which regions to use which asset class.”

Institutions won’t be able to reshape their portfolios overnight. Increases in allocations will occur in stages and won’t involve all asset classes at the same time, says JPMorgan’s Chang. The bank estimates that investors will pour $12.8 billion into dedicated emerging-­markets funds this year.

The shift is likely to continue, considering the powerful fundamentals at play. In China alone estimates of the emerging middle class range as high as 500 million to 600 million people. As their incomes grow, these consumers are demanding more, and higher-quality, food. China has sharply raised agricultural production, but consumption has risen even faster. China became a net importer of food in 2008. “Any portfolio going forward has to incorporate the transformative changes in food and agriculture, energy needs and the effects of inflation,” says Philip Poole, London-based global head of macro and investments strategy at HSBC Global Asset Management.

China also is experiencing a massive migration of people from the country to the cities. The nation’s urban population more than quadrupled between 1985 and 2009, to 607 million from 128 million. By 2030 that urban population is expected to exceed 875 million. Such growth will demand huge increases in infrastructure, including everything from housing, energy, roads and airports to education and health care. “You’re seeing an emerging-markets growth fueled by huge unmet demands,” says Cecilia Mak, first vice president of Hong Kong–based Pacific Group, a pan-Asian macro equity fund.

Similar changes are also under way in other big emerging markets. India’s urban population is expected to grow to some 550 million by 2025 from 325 million today. Brazil’s economic renaissance, fueled by massive commodity exports, has lifted millions out of poverty in the past decade and created a larger and wealthier middle class.

The attraction of emerging markets isn’t simply their dynamic growth rates. Many of these countries have steered their economies extremely well through good times and bad, says Robert Raucci, a managing partner at Newlight Associates, a New York investment firm that specializes in emerging growth stocks. In China, for example, the government was able to draw on its ample reserves to finance a major stimulus program and maintain the economy’s torrid growth. Most emerging-markets economies recovered faster from the recent crisis than their developed counterparts did. “One could bet, as we did, that these economies and equity markets would offer better rewards than the advanced markets,” says Raucci.

For those who worry that emerging markets will have trouble managing continued large inflows of capital, the actions of the authorities should be reassuring. Over the past decade or two, a range of countries have adopted sound macroeconomic policies, cleaned up their financial systems, liberalized trade policies and instituted greater transparency in financial markets. The benefits in terms of growth have been phenomenal. With signs of overheating growing recently, central banks in Brazil, China, India and a number of other emerging-markets countries have tightened their policies this year by raising interest rates or bank reserve requirements or adopting prudential measures to limit the growth of credit. “They won’t let inflation run away and undo what they have done,“ says Morgan Stanley’s Oliveira.

Just a decade ago investors maintained a clear distinction between developed and emerging markets. Indeed, the initial decision by most investors to expand their emerging-markets allocations was driven more by a search for alpha than a belief that the two halves of the global economy were converging. The approach today is profoundly different, and more positive.

“Investors who neglected the emerging markets in 2009 missed one of the great moneymaking opportunities of the decade,” says Newlight’s Raucci. “Those who continue to neglect the EM going forward do so at their peril.” • •

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