Preparing for the Emerging Markets revival

24 Oct 2016

Preparing for the Emerging Markets revival

Relative to Developed Markets (DM), the last five years have been a difficult time to be an Emerging Markets (EM) investor.

EM asset values and revenues have fallen as investors have deployed their capital in other asset classes.  On the flip side, some managers chose a contrarian approach, making opportunistic hires during this period in advance of a much hoped for, long-anticipated revival.    

In recent weeks and months, we have seen increasing press coverage that EM is on its way back. However, investors and commentators alike agree it is still a little too early to determine the extent of this trend. 

What can be said with certainty is that as DM has become a lower yielding environment, the potential returns in EM (up 12% versus DM year to date) are becoming more attractive.  As Merryn Somerset Webb highlighted in her FT Money article, Time for investors to revisit emerging markets, 50% of the MSCI Emerging Markets Index is now made up of ‘structural growth companies’. This should begin to pique the interest of a range of investor types. 

The solid assumption can be made that this will bring greater stability to the asset class going forward, enhancing income for investors.  Other proponents of EM include Mark Haefele, Global CIO at UBS Wealth Management, who in a recent CNBC article offers five reasons why it is a good time to invest in EM.  

What implications does this potential EM recovery have for investment managers and the asset-owning community? Are they staffed appropriately? Which skill sets are potentially missing?  We canvassed some of our investment management and asset-owner clients and found some illuminating perspectives.

Having been underweight in EM for some time, CIOs and investment strategists in asset owners are looking at it more closely. The likelihood of increasing exposure in the near future has risen. 

Several sources believe this resurgence is based principally on macro themes, specifically central bank intervention and liquidity being pumped into the market. Currencies also play an increasingly important role that supports their view on key EM market drivers. There are attractive opportunities at the fundamental level across all EM regions, although asset-owners will have to pay more in fees to access the returns on offer.

Among those outsourcing EM investment to third parties, the feedback is they would like fund managers to build greater macro capability and skills into their EM teams. Buyers of these funds acknowledge there are some fantastic stock-pickers to choose from. However, companies able to harness greater macro experience as part of their investment process will benefit from an attractively differentiated offering.

Difference of opinion

Conversely, fund managers would argue it is their bottom-up research process and ability to analyse what constitutes ‘a good company’ that distinguishes them from the competition.  Their views differ slightly from the investor community on what skill gaps might exist in teams today.

In a world of product proliferation and ‘me too’ offerings, sources have suggested there is a gap in the market for a more ‘high octane’ and absolute return EM product.  This would be significantly more concentrated than traditional benchmark funds, with a circa +80% active share.

Do the larger and more established managers have this skill set currently? Or are asset-owners better served looking to smaller boutiques or hedge funds for these types of funds?

Building China coverage

Another area of focus reported by managers is Chinese market coverage. China now represents approximately 26% of the MSCI Emerging Markets Index. Several investors are therefore looking at strengthening coverage within their EM teams by hiring Chinese nationals, or a linguist at the very least.

From this brief snapshot, it appears brighter times lie ahead for EM. Fund managers report that they are yet to see the EM recovery trend formalising, but given an increase in enquiries from consultants and clients, they are nevertheless hopeful this will solidify after a long period of decline.

The feedback we have received suggests asset-owners and consultants want to see more heavyweight macro thinking from fund managers as they consider moving back into this asset class. 

Moreover, managers of traditional benchmark-aware funds may look at the merits of launching higher alpha products for EM as a means of differentiation and to capture future assets flows.