In this emerging markets panel the participants discuss the role emerging markets will play in pension fund investment strategies as well as how any risks should be managed.
Participants
Max Wolman, portfolio manager, emerging market debt, Aberdeen Asset Management
John Birkhold, partner, Origin Asset Management
Martin Coughlan, senior vice president, head of institutional business, Calamos
1. Allocations to emerging markets by pension funds have increased over the last decade - how will this trend develop over the next decade?
BIRKHOLD: As emerging markets (EM) continue to grow at a faster pace than traditional developed markets, and their capital markets continue to develop, one would naturally assume that the capitalisation of EM stock markets would also outpace those of DM markets and therefore become a larger asset class for institutional investors. However, there are a number of mitigating factors that need to be considered. Firstly, several large EM countries, namely South Korea and Taiwan, will eventually be "promoted" to developed market (DM) status. Second, in many instances the primary beneficiaries of EM growth are often large multi-national DM firms. Therefore, we would not be surprised to see the current EM/DM ratio remain static in equity markets. However, EM fixed interest, currency, private equity and real estate asset classes will undoubtedly become more prevalent in pension fund portfolios over the next ten years.
COUGHLAN: We expect pension funds will continue to gravitate away from "home country bias" and look globally for alpha, including increased exposure to emerging economies. Macroeconomics and long-term secular trends make the case for progressively larger allocations to emerging markets. While economic growth may slow from the rapid levels over the past years, emerging markets are positioned to drive global growth. The well-documented growing prosperity within emerging markets- particularly the expansion of an emerging market middle class-will be a significant driver of investment opportunity for companies, globally.
Capital goes to where it is treated best, and it can move very quickly to find the economies that offer the greatest opportunities, in both developed and emerging markets. In many of the most important emerging markets, we are seeing increased recognition of the benefits of economic freedom. Of course, this is proceeding at different rates, and is not without challenges, so a careful assessment of risks remains essential.
WOLMAN: Pension funds' emerging markets exposure will evolve. Initially funds sought exposure via equity markets but increasingly there is interest in investing in emerging market bond and property markets. A study by J.P. Morgan shows that US pension funds are heavily underallocated to emerging market debt, with less than 1% allocation, but this trend is expected to change. As the asset class matures and the maturities of the bonds issued by emerging markets lengthen, pension funds will be increasingly allocating fixed income exposure to the EM regions in search of higher yields.
2. Which asset classes should pension funds invest into in order to gain access to EM economic growth?
BIRKHOLD: In our view, the best mechanism for capitalising on EM growth is via exposure to global equity growth stocks, where growth is defined as firms that earn and maintain high economic returns while reinvesting organically. By definition, if the developed market world is constrained to low levels of economic growth due to excessive leverage and poor demographics, then companies that are growing their revenue at GDP-plus levels are either taking share from domestic competitors or are benefitting from EM growth. Therefore, a focus on organic profitable revenue growth will provide an investor with the optimal opportunity to profit from EM growth, regardless of where the firm is domiciled.
COUGHLAN: We believe that pension funds should assess the opportunities available across the capital markets we see developing in emerging economies. This will include both the US dollar and local currency sovereign and corporate debt markets as well as equity markets. Equities remain the best way to access growth in emerging markets, according to Calamos research. The Calamos equity valuation model shows that investors are not discounting the potential for future growth. For example, EM, as well as other regions, have median valuations based on free cash flow that are one standard deviation below their long-term averages, which indicates to us better-than-average return prospects. However, the backdrop of likely higher rates and debt deleveraging may hold off the valuation premium in the foreseeable future.
We also believe that as investors look to gain additional exposure to EM, that they consider not only domicile exposure but also economic exposure. In this regard, EM growth can be accessed not only through countries based in emerging markets but also through global companies based in developed markets. This "companies, not countries" approach is a defining feature of the Calamos approach to EM growth.
WOLMAN: Pension funds should consider a range of asset classes - equities, fixed income, property and commodities - when looking to obtain exposure to emerging markets. Investing in EM equities allows an investor to benefit from domestic growth story and the shift from the investment-led to consumption-led growth that is currently under way. Investing in EM fixed income gives investors access to borrowers with healthier balance sheets, more sustainable debt levels and, in case of local currency-denominated debt, the potential to benefit from exposure to appreciating EM currencies. Investing in EM property gives exposure to markets that have not seen the inflated prices, property bubbles and extensive use of leveraged finance observed in the West. A lot of EM countries are commodity exporters so investing in commodities, the prices of which have been on the long-term path of appreciation, also gives exposure to the EM growth story.
3. How risky are emerging markets and how can pension funds manage these risks?
BIRKHOLD: EM equity investors are clearly exposed to higher levels of risk on multiple dimensions. Firstly, higher levels of economic growth provide more opportunity for boom and bust cycles driven by excessive capital flows, which often lead to firm and country specific issues. Secondly, corporate governance and respect for shareholder rights are generally not considered "best practice" in most EM equity markets. Lastly, most EM equity markets tend to be bifurcated with a small number of large firms and a large number of smaller, thinly capitalised companies. As ever, a combination of diversification and a focus on accounting quality can help mitigate these risks.
COUGHLAN: The risks are real but varied, so active management remains of the utmost importance. As their balance sheets have strengthened, many emerging markets no longer entail the same set of risks that they did 20 years ago, and some would argue many emerging markets represent a lower level of investment risk that many developed markets today. Still, we expect continued volatility, given the rapid movement of capital flows, the macroeconomic policies of countries themselves, and the events occurring in developed markets, most notably, those related to debt burdens, currency wars and trade protectionism. Emerging markets are still vulnerable, although perhaps to lesser degree than in the past, to policy missteps elsewhere in the world.
Pension funds can manage the risks of emerging markets by maintaining a preference for countries that are moving in the right direction, in terms of embracing economic freedoms, which can enhance the overall stability of markets and companies within those markets. An emphasis on good cash flows, high return on invested capital, low debt and growth characteristics is essential, especially given the likelihood of more modest global economic growth going forward.
In the current environment, the companies that we see as best positioned to capitalise on EM growth are both local EM companies and larger global companies with geographically diversified revenue exposure. As noted, the manner in which a company is participating in EM growth (source of revenues) is far more important than its location. An opportunistic use of equity sensitive securities, including convertible bonds, can also provide access to EM growth with potentially less downside volatility.
WOLMAN: Emerging markets are not without risks and investors should undertake rigorous due diligence before investing. Emerging markets can boast strong fundamentals and low levels of debt, both in case of sovereign and corporate borrowers. However some risks still remain, including political risk and the risk of interest rate increase due to fundamental or technical factors (e.g. policy mistakes). In order to minimise such risks, a portfolio should be well diversified. Pension funds should not focus on investing in dollar-denominated sovereign debt only, but should allocate across the entire universe and therefore consider investing in local currency as well as corporate bonds.
4. Which emerging markets offer the best prospect of becoming the 'next BRICs'?
BIRKHOLD: In our view, Indonesia has the best opportunity to emerge as one of the leading EM countries outside of the BRICS. It has a large, young population, an abundance of natural resources and is geographically well placed to capitalise on Asian growth. The primary impediments it faces are in the areas of corruption, excessive nationalism and internal ethnic divisions.
COUGHLAN: While the Calamos team closely analyses macroeconomic factors, including those within emerging and frontier markets, the firm's investment process is focused primarily on identifying global investment themes and businesses with diversified revenues and participation in EM growth themes. We are more concerned with finding those businesses wherever they may be headquartered and less focused on particular countries as a means to determine our participation.
WOLMAN: Some investment managers have homed in on the ‘BRIC' countries of Brazil, Russia, India and China, based on the theory that these nations are set to become the world's most dominant economies.
While there is no doubting the importance of these populous countries which are already among the main contributors to global economic growth, BRIC is a ‘top-down' idea that can create a distraction - ultimately restricting the investment universe. We prefer to choose our investments from an unconstrained, global emerging market debt universe, using bottom-up analysis.
Although if you were to push us for an answer, Indonesia and also some of Latin America's smaller economies, like Peru and Colombia, are experiencing high levels of growth.
