A common theme in recent years among local government pension schemes has been the desire to explore opportunities for diversifying their investment portfolios as widely as possible.  Unlike most schemes within the private sector, they have the advantage of a relatively long investment time horizon and have generally maintained higher levels of equity exposure.  This has led them to explore alternatives to equity investment.  However, they have also been keen to ensure that their listed equity assets are as well diversified as possible.

Investment by pension schemes in emerging markets is by no means a recent phenomenon, though the nature of the asset class has been changing.

What are emerging markets?
Markets are classified as ‘emerging’ according to some arcane definition of income per capita; typically, these markets are moving from closed, ‘domestic investor only’ markets to open markets.  This move usually occurs in conjunction with rapid economic growth and structural reform taking place within the country.

Emerging markets vary considerably in terms of size and economic importance; however, over the long-term, these economies are broadly aiming to bring their economic and living standards in line with those of the developed world.  The economic growth of emerging markets tends to be faster than in developed markets.  As a result, the profits of companies in these markets can grow faster, making them potentially attractive for long term investors.

However, the levels of risk tend to be higher.  The markets tend to be more vulnerable to periods of global uncertainty, their currencies can be more susceptible to sharp falls, governance is less well developed and the political risks tend to be much greater.  Therefore, although we would expect returns to exceed those from developed equity markets over long time periods, the pattern of returns is likely to exhibit a higher degree of shorter term volatility. 

The backdrop to corporate governance is clearly unsatisfactory.  Many companies are still controlled by private owners, shareholder rights can be limited and voting almost impossible.  This can present a particular challenge for local authority funds, many of which are keen to be at the forefront in demanding higher standards of governance.   

There are a number of different benchmark indices used within the emerging markets area, so there is no single definition of which markets are included.  However, one of the most widely used indices, the MSCI Emerging Markets Index, comprises 25 different countries, with these markets representing around 10% of world stock market capitalisation.  Historically, emerging market investment was seen primarily as being focused on the rapidly developing Asian economies.  However, Asia now represents only around 50% of the Index, alongside significant representation from South/Central America (20%), Europe/Middle East (20%) and Africa (10%).

The index does reflect the relative market capitalisations of the countries, which results in quite a high level of concentration.  Five countries account for over 60% of the index (Russia, Brazil, China, South Korea and Taiwan).  One issue for investors is to be clear as to whether there is any overlap between their emerging markets and other regional equity benchmarks, particularly where the scheme is investing on an index-tracking basis.

Across local authority pension schemes, it is difficult to be precise about the level of investment within these markets, as the classification of investments is not consistent across managers and mandates.  However, a broad estimate would suggest that somewhere in the region of £3-5bn of local authority assets are currently invested in emerging markets.

Changing nature of the asset class

Historically, emerging economy stock markets tended to be heavily influenced by capital flows from foreign (largely Western) investors.  Strong gains in Western markets and rising investor confidence would see investors allocating more money to the emerging market asset class.  These large capital flows into relatively small markets would push up prices and stock valuations.  A setback in Western markets would then lead to a fall in investor confidence and the capital would be ‘repatriated’ to the seemingly more defensive home markets.  The selling of the large index constituents favoured by foreign investors would result in sharp index falls.  Therefore, despite the robust economic growth background within the economies, market returns were driven by the fluctuating confidence levels of overseas investors.

One significant change in recent years has been the growth in the domestic investor base.  In addition to the increase in local retail investment, the domestic banks, insurance companies and investment companies in these countries have also become significant institutional investors within the markets.  Indeed, many of these institutions have become significant providers of capital to Western equity and bond markets.  This is helping to reduce the vulnerability to external flows and should therefore encourage investors to be more willing to make a long term commitment to the area.

In addition, more of the companies in these markets are now being researched by global research analysts rather than specialist country analysts.  So stocks such as Telekom Indonesia, Thai Beverage, OTP Bank (Hungary) and Teva Pharmaceutical (Israel) are more likely now to be researched by the appropriate industry specialist and assessed alongside their competitors in other countries.  Not only does this mean that the research is more likely to be carried out by an individual with a better understanding of the industry and business, but also that valuations and share price performance are less likely to be influenced by individual country factors.

Dedicated managers

Local authority investments in this area were traditionally achieved through asset allocation decisions made by the schemes’ balanced managers.  These managers would often have specialist emerging markets teams, and a small proportion of the overseas equity allocation would have been made available to them to manage independently of the other regional teams.

There has been a general move away from balanced managers by most local authority schemes, with the overseas equity assets being increasingly taken on by specialist global equity managers.  It is important for schemes to understand how each of these managers handles investments in emerging markets.  In many cases, these firms are researching stocks on a global basis and emerging markets stocks are included in portfolios on their merit vis a vis other global competitors.  Where managers have limited analyst resource overall, it is important to be sure that such stocks are not being ignored in the research process. 

We have not seen many schemes choosing to employ a dedicated emerging markets manager.  These managers are likely to contain the highest levels of specific expertise on these countries and many have established strong long term reputations.  Arguably, these markets are still relatively inefficient relative to developed markets and one would expect active management based on fundamental research to have a good chance of adding value.  However, it is open to debate whether the stocks are best considered in isolation or as part of a global equity universe but, increasingly, we would see any distinction as somewhat arbitrary and potentially unhelpful.

Many schemes have been reluctant to see their roster of managers increase further.  They have been appointing specialist bond and equity managers, and making new investments in property, private equity and sometimes hedge funds and infrastructure funds.  This has resulted in a significant increase in the number of managers employed, with a resulting increase in monitoring requirements.  For a scheme with 70% in equities, and perhaps half of this overseas, then exposure to emerging markets may be as little as 3-5% of the total fund.  Therefore, schemes have generally preferred that their global equity manager could demonstrate competence in this area rather than making an additional manager appointment. 

Emerging Market Debt

One area where local authority funds have been increasing exposure to emerging markets recently, admittedly from a very low base, has been within emerging market debt.  There has been a trend for schemes to increase the flexibility of their bond managers’ mandates to allow them to invest in a wider range of instruments.  With yields on UK government bonds being forced down to such low levels in recent years, managers have increasingly looked to ‘riskier’ assets in an attempt to improve returns. 

The risks with this approach have been demonstrated in recent weeks as investors’ appetite for risk has fallen sharply and credit spreads have widened considerably.  Having said that, we are not uncomfortable with emerging market debt being available to bond managers as a potential investment at the manager’s discretion, subject to there being some limits on the size of investment.  Indeed, the asset class  clearly offers better relative value after the correction!  A significant number of emerging market countries now carry investment grade credit ratings (i.e. BBB or better) from the rating agencies, and managers have increased their capabilities in terms of being able to research this area of the market.  We would not advocate including a specific benchmark weighting to the asset class, but would rather allow the manager to invest on a tactical basis where they see opportunities.

Conclusions 

Emerging market equity investment has become an integral part of a scheme’s overseas equity allocation.  Company research and incorporation into portfolio construction need to be a key part of a global equity manager’s credentials to manage such assets.  However, managers’ approaches do vary and it is important that schemes satisfy themselves that their managers are positioned to take full advantage of the broad opportunity set.