Published in partnership with Northern Trust Asset Management.
With major central banks looking to finally ease interest rates after years of tightening, institutional investors are hoping payback from the segment can improve and they might savour some of the long-promised success across their emerging equity market portfolios.
That could help diversify risk at a time when overall fund returns have largely been driven by international sharemarkets, and fund managers are facing increasingly expensive valuations in developed markets like the US and UK.
Andrew Fisher, the head of investment strategy at Australian Retirement Trust, says emerging markets largely remain attractive for their strong economic fundamentals over an extended period.
“Markets with higher economic growth should bring a return premium to them,” he says.
“Understanding how to access that premium and making sure you deliver it to your members is quite the challenge at times, but that’s certainly the reason we think there is a premium to be gained if we can do it successfully.”
The $300 billion ART has roughly 30 per cent of its holdings in global equities, of which 11 per cent is within emerging markets. It also holds EM exposure across some of its alternative assets as well as in the fixed income space.
Disappointing run
Investors have made a beeline for emerging markets for nearly twenty years, lured by the phenomenal erstwhile economic growth rates in China and elsewhere, and boosted by the tailwinds of globalisation.
But over the last decade, the asset class has seen returns drag repeatedly due to a variety of factors including extended quantitative easing in developed markets, then the Covid-19 pandemic, the strengthening of the US dollar as well as geopolitical events.
Over a 10-year horizon, the MSCI Emerging Markets Index has delivered returns of 2.79 per cent against 9.16 per cent from the MSCI World Index, prompting a less-than-bullish approach from many large investors.
Australian superannuation funds too have been relatively underweight on the equity side of emerging markets in recent years, with allocations trailing the nearly 11 per cent weighing that emerging markets have in the MSCI All-Country World Index.
According to NAB’s Super Insights Report late last year, 35 of the 41 super funds surveyed were invested in EM, with an average allocation of 4.9 per cent deployed to the asset class.
While asset owners have rarely pulled money from emerging economies, their weightage has shrunk on the margins as overall investments in international equities have rapidly ramped up.
For instance, Australia’s sovereign wealth fund – the Future Fund – saw its emerging markets holdings lift to 6.8 per cent in the March quarter, from 5.9 per cent a year earlier. By comparison, its global equities holdings jumped to 20.3 per cent from 17 per cent a year earlier, while domestic equities rose to 10.1 per cent from 8.8 per cent.
Similarly, Brighter Super CIO Mark Rider said the $32 billion fund achieved strong active performance from its systematic Emerging Markets manager, but with limited weight for the segment, most of its strong FY24 returns were driven by developed markets, which has more than 90 per cent share of its global equity portfolio.
Finding Value
Fund managers have typically used emerging market investments to diversify the growth exposure in their portfolio.
Take for instance, a standard global equity portfolio dominated by a profile of the US, Europe and other developing countries, which investors believe brings a typical concentration of growth drivers.
“Emerging markets are a very strong diversifier against that type of growth because EM economies are at a different stage of their economic cycle, they’ve got a different drivers of growth, they’ve got a different sector composition,” says Ben McCaw, Co-Head of the Choice Diversified Portfolio at MLC Asset Management.
That diversification has proven useful during a period when developed economies have tended to run on a macro cycle that is getting more and more globally consistent, such as the post-pandemic inflationary cycle.
While developed markets have struggled to bring down inflation, emerging economies – more used to dealing with high inflation – responded much harder and contained it much more easily, getting growth back on track far quicker.
Other positive attributes for EMs include cheaper valuations, currency diversification, and higher real rates, McCaw says. MLC, which is part of retail super fund Insignia, has been overweight on emerging markets with about 15 per cent invested in total across funds. Its biggest allocations are also in China, India, South Korea and Taiwan, some of which is focused on the mid-cap technology sector in Asia.
UniSuper chief investment officer John Pearce this month also attributed his fund’s strong FY24 performance to investments in the Indian and Japanese markets as well as an overweight position in technology. The $135 billion fund delivered a 9.2 per cent return, helped by its Asian focus that included investments in large cap companies in India.
Northern Trust Asset Management deputy chief investment officer and chief investment officer of global equities Michael Hunstad says a cornerstone of the investment case for investing in emerging markets – including China – has been the idea of capturing the high GDP growth of these economies in the form of strong equity returns.
“On the surface that looks good,” Hunstad says.
“But the reality is that it doesn’t matter which country you’re in, if you run over time and look at what’s the relationship between GDP growth and equity market returns, it comes up with a big zero at the end of the day.”
In China, GDP growth of around 6.2 per cent a year over the past decade has translated into a 3.1 per cent a year return from equity markets, net of share issuance, Hunstad says.
He says that while there “isn’t really a relationship between GDP and equity market returns”, there is a very strong relationship between a country’s marginal product of capital – how good they are at turning an incremental dollar of investment into something productive – and equity returns.
“So I think we have to reassess how we think about the macro influence of growth on equity returns,” Hunstad says.
This gives rise to a debate over whether China should be included in emerging market exposure, because “over the last decade, that marginal product of capital has gone down precipitously” in China, Hunstad says.
At the end of the day, however, Hunstad says NTAM is “marginally overweight emerging markets, mainly because we like India [and] we like Southeast Asia more than we are concerned about the risk over the very near term around China”.
Return on risk
Most large investors are in agreement in expecting consistently higher returns from EM, given the elevated risks associated with investing there. Where they differ somewhat is in how they frame these expectations and in how they benchmark the investment.
“Emerging markets should outperform over the long term and so assuming valuations don’t change, then you could reasonably expect to earn an extra 2.5 to 5 per cent compared to developed markets, on average,” MLC’s McCaw said.
He says broad valuations across EM are pretty cheap at the moment and could increase, so the performance differential could be higher.
Like many other Australian funds, MLC relies on the expertise of its specialist external managers to find the individual securities for its EM equity investments. It also has some synthetic exposure through derivatives – managed internally, particularly in markets like China.
A larger fund like ART, which also uses external managers with a bottom-up stock picking approach, says as a rule-of-thumb it considers emerging markets as having about 1.2 times the risk of developed markets.
“What that means is, if you have an equity risk premium of 4 per cent in developed markets, the its basically developed markets plus at least 1 per cent. If that’s not achievable, then we wouldn’t find the emerging market attractive,” ART’s Fisher says.
“Our lived experience has been more like developed markets minus 1 per cent over a few years, which is why it’s a little challenging,” he added.
The high bar has often led fund managers to correlate EM to domestic equity returns, given the similarity in macro drivers. That often means EM allocations are more correlated to domestic equity than the global portfolio.
“The external side of the Australian economy has an element of emerging markets about it because it’s cyclical, it’s commodity-based, and therefore often operates at the same central cadence as emerging markets,” MLC’s McCaw said.
Vulnerable to USD, trade
While emerging economies have limited linkage to developed markets, they have seen an inverse correlation to the strengthening US dollar in recent years, given abundant US dollar-denominated debt raised across their corporate and government sectors.
With the Federal Reserve on the cusp on relaxing its monetary policy, fund managers are raising hopes an easing US currency could trigger an improvement in liquidity for emerging markets and also open up investment opportunities.
“What’s been challenging for all of us over the past five plus years is diversifying away from US. Betting against the US is really hard when it has 60 per cent of the global capital. Diversifying away from that is a risky position,” ART’s Fisher says.
“If you do see the US dollar fall from here, there are a few things coming together to suggest that emerging markets may do a little better.”
Another factor to consider has been the growing geopolitical tensions at a time when trade links have evolved between emerging markets themselves.
“Emerging markets used to rely on trading with developed markets for their growth. As they have evolved, there’s a lot more intra-EM trade between the EM economies,” MLC’s McCaw says.
“And so if that starts to slow down because of geopolitical frictions developing between China and the West, it would inhibit the growth rate of emerging markets.”
