Investing In

Nomura Asset Management U.K. Ltd Global Emerging Markets Strategy

INDEX OF PUBLICATIONS

• The case for emerging markets and regional versus global management considerations Palgrave Macmillan, 2009, Pensions Vol. 14, 1, 36–46 • Q&A: how to get the best from Emerging Markets Engaged Investor, Nov-Dec 2008 • Emerging markets still in favour Financial Times, 20th Oct 2008 • Expert View: Emerging Markets Engaged Investor, Trustee Handbook 2009 • Emerging markets: divide and conquer European Pensions, Sep 2008 • China and India – Is it time to invest now? Engaged Investors, Sep-Oct 2008 • Emerging Markets in the grip of inflation: winners and losers Global Pensions, Sep 2008 • The poacher’s guide to game-keeping in Emerging Markets Global Pensions, Sep 2008 • Who’s got the Alpha in Emerging Markets? Global Pensions, Jun 2008 • Investing in “Emerging” Europe Engaged Investors, May-June 2008 • No quick fixes Professional Pensions, 15th May 2008 • Emerging Markets provide the opportunity to add value Engaged Investors, Trustee Survival Guide, May 2008 • Investors debate decoupling theory Global Investor Magazine, Apr 2008 • Taking a regional approach to Emerging Markets Global Pensions, Apr 2008 • Global Emerging Markets Engaged Investors, Mar-Apr 2008 • Where is the Alpha? Investment World, Feb 2008 • Safety in Numbers Investment World, Feb 2008 • All about Emerging Markets Investing Engaged Investors, Nov 2007 • How best to access Emerging Markets Alpha Global Pensions, Nov 2007 • Alpha spurs on Emerging Markets Global Pensions, Oct 2006

EUROPEAN PENSIONS AWARDS 2009 - Winners supplement

Highlighted winner: Emerging Markets Investment Manager of the Year Nomura

eeking out potential in the less developed markets is a challenging role at which only the best can succeed; yet for those that do, the rewards Sfor European pension funds investing in this area can be great. This award recognises those managers that have shown a dedication to the emerging markets space with a view to achieving performance, whatever the market conditions and often in areas where information flow is in short supply. Nomura Asset Management was presented with the coveted prize of Emerging Markets Manager of the Year award for its unique and innovative approach to the emerging market space; its presence in the market; its expertise; and for creating a regionally focused emerging strategy accessible even to smaller funds. Nomura is focussed on responding to the needs of European pension funds and uses its specialist asset management capabilities to meet those needs. The firm has provided asset management services to European pension funds since 1984 and through continued success in most market conditions has grown its assets in emerging market equities significantly. Nomura aims to deliver alpha to the European market through innovative strategies including core, absolute return and high alpha structures coupled with excellent client service. A core objective is to provide European clients with the alpha they are seeking within a risk controlled framework. Nomura’s emerging strategy, now three years old, has delivered outperformance in both rising and falling markets by combining three specialist emerging market managers from each of the three main regions (Asia, Latin America and EMEA) into a single global emerging market product. Clients are able to get the benefit of the three managers, but only have to deal with one. They also get the benefit of manager diversification and uncorrelated alpha. Nomura has clearly responded to the needs of pension funds by creating this regionally focused emerging strategy. Given governance and budget The European Pensions Emerging Markets Manager constraints faced by most pension funds, accessing regional expertise was of the Year award was presented to Nomura Asset once something only the largest could enjoy. Nomura's product opens this Management. Receiving the award is David da Silva. market up to all funds. Head of GEM Strategy (centre) at the firm. The award Its unique & innovative offering, coupled with independent third party research was presented by Comedian Chris Barrie (left) along puts it ahead of the game in the emerging market space. Congratulations to a with one of the judges, Matt Wilmington, International deserving winner. Benefits Actuary, Hewitt (right).

www.europeanpensions.net/awards 31 Original Article The case for emerging markets and regional versus global management considerations Received (in revised form): 20th October 2008

David da Silva is the Head of GEM Strategy at Nomura Asset Management UK Limited. He has been with the ﬁ rm since 2004. Before this, he held product development roles in Morley Fund Management in London, with speciﬁ c focus on Japan, Singapore and the United States. He commenced his investment career at Commercial Union Investment Management in South Africa as an analyst and fund manager in 1996. In 1999, following Commercial Union’ s disinvestment from South Africa, he moved to London to work at Commercial Union’ s investment management business, Morley Fund Management. He has a B.Com. (Hons) degree from the University of Cape Town, South Africa. In 1999, he attained the Chartered Financial Analyst designation.

ABSTRACT This paper considers whether there is a strategic case to be made for investing in emerging markets and, if so, whether the timing is still right to invest. The question of how best to achieve emerging market exposure is then addressed, in particular whether using a collection of regional specialists is superior to using a single global emerging market manager. Independent research from Oliver Wyman supporting the case for regional specialists is then reviewed. Pensions (2009) 14, 36– 46. doi:10.1057/pm.2008.36

Keywords: emerging market equities ; case for regional specialists

EMERGING MARKET seriously undermined, with emerging markets PERFORMANCE declining more rapidly than their developed Emerging market equities have performed counterparts; the MSCI EM index declined by 33 relatively well over the 3 years leading up to per cent versus the 26 per cent fall in the MSCI September 2008, comfortably outperforming World index (performance up to the end of developed markets, with a return of 28.4 per cent September 2008 in US dollar terms). In an versus, for example, the 0.6 per cent decline in increasingly globalised and interconnected world, the S& P 500 in US dollar terms (Figure 1) . This total decoupling always seemed unlikely, but what relative strength had encouraged many to is true is that emerging countries are less subscribe to the ‘ decoupling’ argument, which vulnerable to a developed world slowdown than suggests that emerging markets are no longer they have been in the past. Better ﬁ scal balance dependent on growth in the developed world to sheets, increasing domestic demand, massive public maintain their own growth rates. Over the past infrastructure programmes and high savings rates year, however, the decoupling thesis has been have all helped. Furthermore, growth in trade amongst emerging economies has risen substantially. Therefore, the dependence on the

Correspondence: David da Silva, Nomura Asset Management UK Limited, United States, Europe and Japan is less, but still Nomura House, 1 St Martin ’s-le-Grand, London EC1A 4NT, UK. important.

3 year cumulative performance (%) to September '08

110 110

90 90

70 70

50 50

30 30

10 10

-10 -10 Jul-06 Jul-08 Jul-07 Jan-06 Jan-07 Jan-08 Mar-06 Mar-07 Mar-08 Nov-06 Nov-07 Nov-05 Sep-05 Sep-06 Sep-07 Sep-08 May-06 May-07 May-08

MSCI World S&P 500 MSCI EM

Figure 1 : Cumulative performance: 3 years. Source : Datastream, Nomura. Monthly data as of 30 / 09 / 2008.

Over the longer term, the extent of trend should be consistent going forward. This outperformance has been striking. Figure 2 shows chart puts into perspective the fact that despite MSCI EM performance in US dollar over the 20 emerging countries only accounting for a quarter years up to the end of July 2008 (the longest of world GDP, they account for 50 per cent of period available, as this was the inception of the global GDP growth. date of the index). Another notable feature is how strongly the Growing, but is this refl ected in the markets have collectively bounced back following market? the highly publicised market crises of the late Emerging economies are growing, but is this 1990s and early 2000s, including the South East being refl ected in their share of global market Asian crisis in 1997, followed by the Russian debt capitalisation? There is a relationship in many default crisis and the dot.com fallout. Despite countries whereby their relative share of global these knocks, these markets have recovered very GDP converges to a similar proportion of global sharply. market capitalisation. As an illustration of this, Figure 4 shows this relationship for Japan. In the What has been driving this late 1980s, during the Japanese stock market performance? bubble, Japanese equities accounted for 50 per Strong economic growth has been key in driving cent of global market capitalisation, despite the this outperformance. Figure 3, depicting real GDP economy only accounting for 15 per cent of growth rates, highlights how emerging markets world GDP. After the bubble burst, the two ratios have seen growth accelerate over the past few eventually came into line with Japan’ s market years. From the narrow growth advantage in the capitalisation and GDP percentage ratios, levelling 1980s and 1990s, this differential has increased to off near 10 per cent . unprecedented levels in the past few years. The Figure 5 highlights the fact that despite the World Bank is likely to revise down the estimated aforementioned growth advantages, emerging 2008 and 2009 fi gures in due course to refl ect market capitalisations lag far behind their the impact of the credit crunch, but the overall contribution to the global economy. Emerging

Cumulative performance (%) since January '88 2000 2000 1800 1800 1600 1600 1400 1400 1200 1200 1000 1000 800 800 600 600 400 400 200 200 0 0 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

MSCI World S&P 500 MSCI EM

Figure 2 : Cumulative performance: 20 years. Source : Datastream, Nomura. Monthly data as of 31/ 07 / 2008.

Market outlook - real GDP growth rates 8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0 1980-2000 2005 2006 2007 2008 2009 World OECD Developing countries

Figure 3 : Real GDP growth rates. Source : Global Economic Prospects 2008, The World Bank 2008.

markets are nearly 30 per cent of global GDP, but total. The ﬁ gure also shows the allocations to the are only 11 per cent of global market main emerging market regions: 50 per cent of capitalisation. Therefore, there is still some way to emerging market capitalisation lies in Asia and go. To highlight this point, Figure 6 illustrates approximately 25 per cent in each of Latin how the MSCI World index is currently America and Europe, the Middle East and Africa apportioned: the United States, Canada and (EMEA) . Europe account for 75 per cent, whereas This reﬂ ects the current position, but more emerging markets account for 11 per cent of the important is the trend behind the numbers. In

60%

50%

40%

30%

20%

10%

0% 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

JAPAN % Global Mcap JAPAN % Global GDP

Figure 4 : Japan market cap versus GDP percentage.

35%

30%

25%

20%

15%

10%

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 EM % of mcap EM % of GDP

Figure 5 : Emerging market cap versus GDP percentage. Source : IMF, datastream.

June last year, emerging markets collectively investors’ weighting to this asset class on average ranked alongside Japan with approximately 9 per is less than 5 per cent. Consequently, there is cent of the MSCI World index; in the past year, ample room for allocations to grow. as a result of relative outperformance and increasing market capitalisation, this has moved to LONG-TERM DRIVERS: 11.4 per cent, whereas Japan has remained at DEMOGRAPHICS, SKILLS around 9 per cent. AND PRODUCTIVITY Despite the increased weight in global indices, The medium-term growth prospects look good, there is anecdotal evidence that institutional but investors should focus on the long-term

2.8% 9.0% 46.3% 1.5% EMEA, 2.9%

EM Asia, 5.7%

Latin America, 2.8%

29.0%

Figure 6 : MSCI emerging markets market capitalisation allocation. Source : MSCI Red Book as of July 2008.

prospects: where will emerging markets be in 5, With a declining population and labour force, 10 or even 20 years’ time? In order to obtain a growth will come under substantial pressure. perspective on these outcomes, consideration Another factor infl uencing growth is increasing should be given to key drivers of economic labour productivity, a key determinant of which is growth, population demographics, skills and skills levels and these are increasing sharply. Figure productivity. 8 shows the number of science and engineering Emerging markets contain 80 per cent of the students graduating from universities in Japan, the world ’s population: this is a young and growing United States, the EU, China and India. Although population both in absolute and relative terms. As the data are slightly dated, they give a good an indication of the scale and numbers involved, indication of trends in this area. consider the fact that in the fi rst quarter of 2008, Between them, China and India produced a period of signifi cant economic turmoil across 1.2 million graduates in these disciplines in the world, China Mobile signed up 21 million 2002/ 2004, more than Japan, the United States new subscribers. This is the equivalent of about a and the EU combined. Although these data are third of the United Kingdom’ s population open to some criticism (China and India’ s purchasing a phone contract in 3 months. If the defi nition of ‘ engineer ’ can be somewhat broader Chinese population is buying phones, one can than developed nations’ defi nitions, and emerging extrapolate the exponential growth in demand for market graduates are not necessarily educated to all sorts of other consumer goods, the future the same standard as those of other countries), it demand for housing, education and anything else is clear that emerging markets are no longer just you care to mention. the home of low-skilled manufacturing. Apart from sheer numbers, emerging markets Increasingly, they can compete in more high-tech, exhibit favourable demographic profi les. Basically complex manufacturing and in complex services, they have relatively young populations. Figure 7 an example being the Indian IT software industry. shows the population pyramids for Indonesia and Higher skills are also important in that they can Japan. Indonesia’ s profi le exhibits a young free economies from developing in the traditional population, represented by the width of the way and enable them to leapfrog some stages of bottom bars of the fi gure. Japan is the other development. Therefore, in many emerging extreme. Japan’ s fertility rate is almost half that of regions, communities are, for example, completely Indonesia. And with a tight immigration policy, by-passing fi xed-line telephones, and have moved the population is expected to peak around 2015. straight to mobile technology.

Indonesia: 2008 Male Female

12 10 8 6 4 2 0 0 2 468 10 12 Population (in millions) Source: U.S. Census Bureau, International Date Base.

Japan: 2008 Male Female

6 5432100 1 23456 Population (in millions) Source: U.S. Census Bureau, International Date Base.

Figure 7 : Population pyramids for Indonesia and Japan. Source : US Census Bureau, International Data Base.

Japan

2002-04 US 1990-91

China

India

0 100000 200000 300000 400000 500000 600000 700000

Figure 8 : University graduates in engineering and science. Source : Eurostat 2003 and JP Morgan – June 2005.

PRODUCTIVITY emerging markets remain signiﬁ cantly ahead of Improving skills levels is facilitating productivity those in advanced economies. According to a growth and is ensuring that these rates in recent report by the Conference Board, 1

productivity growth rates in 2007 for Europe, indices. Table 1 highlights the correlations Japan and the United States were low, ranging between the MSCI EM index and some of the from 1.1 to 1.4 per cent. For BRIC countries other developed market indices, over the past 5 (Brazil, Russia, India and China) on the other and 20 years. It is clear that emerging markets hand, the average productivity growth accelerated have reasonably low correlations with other to 8.3 per cent in 2007, from 7.9 per cent in equity markets. Consequently, there are 2006 and an average of 7.5 per cent between diversifi cation benefi ts from the introduction of 2000 and 2005. What should be borne in mind, this asset class. And this is true both on a however, is that these economies are starting from medium-term and on a longer-term basis. a lower base and consequently general As mentioned, emerging markets have a higher productivity levels in emerging economies are still volatility of returns than developed markets and very low, at between 10 and 40 per cent of the therefore, on the face of it, look more risky. But US level, for example. As wages are much the question that all investors should consider cheaper, the labour cost per unit of output is, foremost is, do the returns compensate for this however, more competitive in emerging countries higher risk? Table 2 highlights the returns and than developed ones. As the report highlights, associated volatility of the S& P 500, MSCI World ‘ Rapid adjustment to competitive pressures and and MSCI EM. greater innovation in emerging economies signals The table shows that although emerging fundamental and lasting changes in the global markets have been more volatile over the past 5 competitive landscape’ . 1 and 10 years, it also is clear that returns have far outstripped those from developed markets. The RISK VERSUS RETURN key fi gures in the table here are the returns per When considering the addition of any asset class unit of risk in the furthest right-hand columns. to a portfolio, it is important to ensure that it not Emerging markets have consistently added more only enhances returns, but does so without a return on a risk-adjusted basis than the developed commensurate increase in risk. In isolation, markets. emerging markets have exhibited higher volatility of returns than their developed market peers, but HOW BEST TO ACHIEVE one should consider how this return profi le EMERGING MARKET EXPOSURE? complements the rest of the assets in the fund. If the case for emerging market exposure is This is best understood by looking at the compelling, what is the best way to achieve this correlation statistics between the various equity exposure? One of the major challenges for any

Table 1: World market correlation ﬁ gures MSCI EM MSCI World S & P 500 TOPIX FTSE 100 MSCI Europe

5-year correlation MSCI EM 1 — — — — — MSCI World 0.87 1 — — — — S & P 500 0.73 0.95 1 — — — TOPIX 0.62 0.62 0.47 1 — — FTSE 100 0.83 0.91 0.78 0.54 1 — MSCI Europe 0.85 0.96 0.86 0.54 0.96 1

20-year correlation MSCI EM 1 — — — — — MSCI World 0.67 1 — — — — S & P 500 0.61 0.86 1 — — — TOPIX 0.40 0.68 0.35 1 — — FTSE 100 0.52 0.83 0.69 0.46 1 — MSCI Europe 0.61 0.89 0.74 0.47 0.90 1

Source : Datastream, Nomura. Monthly data as of 30/09/2008.

Table 2: Risk and return characteristics improve returns. Oliver Wyman, a management Look-back period Returns SD Return per consultancy with particular expertise in the (%) (%) unit of risk investment industry, were commissioned to carry 5 years out research to assess whether these beliefs could MSCI World 7.9 11.6 0.7 S & P 500 5.2 10.3 0.5 be supported by observable data. MSCI EM 19.0 21.5 0.9 MSCI Europe 11.5 14.5 0.8 INDEPENDENT RESEARCH ON TOPIX 3.7 15.1 0.2 REGIONAL VERSUS GLOBAL 10 years MANAGEMENT MSCI World 4.3 14.3 0.3 S & P 500 3.1 14.4 0.2 Oliver Wyman’ s project objectives were ﬁ rstly to MSCI EM 14.8 22.5 0.7 examine whether, based on historical MSCI Europe 5.2 16.4 0.3 TOPIX 4.1 18.8 0.2 performance, there was evidence to support that a product composed of specialist regional Source : Datastream, Nomura. Monthly data as of 30/09/2008. managers had the potential to outperform global emerging market funds. Secondly, they manager is how to deal with such a wide considered whether combinations of regional universe as the global emerging markets and how specialists were more risky than single global to analyse so many diverse opportunities. It is a managers. Their report entitled ‘ Emerging Market very challenging mandate; consider the facts: Product Analysis Year end 2007’ issued on 22 February 2008 is available on request, and — 3 regions (Asia 50 per cent, EMEA 25 per represents the third annual update to their analysis cent and Latin America 25 per cent) originally conducted for the end of 2005. — 26 countries (MSCI) Oliver Wyman reviewed fund data sourced — 27 currencies from Bloomberg for the 7-year period ending in — 79 languages; and December 2007. Starting with a comprehensive — over 800 stocks in the MSCI benchmark, out universe of just over one thousand funds, this was of a broader universe of around 14 000 stocks. screened to exclude duplicate funds, single country or region funds, and so on, to end with This is a lot for one manager to cover well. a cleansed universe of 403 funds, representing over $ 300 billion of assets under management REGIONAL MANAGEMENT BEST (AUM), one-third of which came from regional On the basis that inefﬁ ciencies are greatest at specialist managers . stock level, alpha can best be generated by They then captured all the return data and employing a combination of regional experts, constructed composites comprising the averages looking for the best stock pickers in each region. of each quartile for each region and globally. The The thinking is as follows: regional averages were linked together using neutral MSCI weights, and then compared — Regional specialists are likely to have a better against the global peer averages. For the third understanding of their regions. year in a row, the analysis revealed that there was — This enhances country allocation decisions a clear alpha advantage for the combination of and improves stock selection – both in terms regional specialists over the generalist global of depth of understanding of individual emerging managers. Over the 7-year period, the companies and breadth of coverage of the average top quartile regional managers in universe. combination outperformed the average top quartile global manager by more than 2.3 per Key expectations are that better information cent on an annualised basis up to the end of should produce better investment decisions, and December 2007, as shown in Figure 9. On an that this in turn should produce more alpha and individual calendar-year basis, the analysis also

Seven year annualised total returns

30%

28.7% Composite fund of the average of the top quartile 27% performing regional specialists maps aganist 3rdth 26.3% percentile performance Global EM 1Q average maps against 10th 25% percentile performance 24.0% 24% MSCI EM return maps against 28th percentile performance 22.8% 22% Composite fund of average performance of regional specialists maps aganist 38th percentile performance 20% 19% Key 5th percentile Q1/Q2 boundary Median 16% Global EM performance 15% Q3/Q2 boundary 95th percentile

Figure 9 : Oliver Wyman: GEM Universe 7-year annualised return spectrum. Source : Bloomberg, MSCI, Nomura, Oliver Wyman analysis.

highlighted the fact that regional specialists return per annum at a lower tracking error, 4.9 outperformed in 6 out of the past 7 years. per cent versus 5.6 per cent, compared with the The analysis also highlighted a risk advantage global managers, as depicted by the blue shaded when going the regionalist route. Running a area. Monte Carlo analysis, which entailed generating random combinations of regional specialists, OLIVER WYMAN FINDINGS: Oliver Wyman concluded that although individual REGIONAL SPECIALISTS OFFER regional managers had higher active risk than BETTER RISK-ADJUSTED global managers (Figure 10, fi rst panel), a RETURNS combination of them diversifi es this risk away, so Drawing all this together, Oliver Wyman’ s research that on average they presented the same level of supported the rationale for co-ordinating the risk as the global managers (Figure 10, second expertise of regional specialists into a single panel). product. Not only was there a clear alpha Moreover, when looking at above-average advantage, there was also no increase in tracking managers, that is those managers who have error associated with these combinations. outperformed over the mean over the period, Furthermore, if better-than-average managers which is presumably what any selector of were considered, then there was clear risk managers would probably be focusing on, the reduction, in terms of tracking errors. combination of regional managers showed a clear risk advantage as compared to global managers, as CONCLUSION highlighted on the simplifi ed scatter in Figure 11. As highlighted, there is a growing economic case Considering returns and tracking errors over 5 in favour of a strategic allocation to emerging years up to the end of 2007, the regional markets in most pension funds. The fundamentals specialist combinations delivered 2 per cent more are solid and are supportive of long-term growth

Global vs. composites fund Tracking error distribution over 5 years Global vs. regional manager Composite 5.0% Average tracking error comparison over 5 years 30% Global 5.0% 12% 25% 9.7% 10% 9.3% 20%

7.9% 15% 8%

Proportion 10% 6% 5.4% 5.0% 5% 4% Tracking error 0%

2% < 3% > 15%

0% 3 - 3.75% 5.25 - 6% 6 - 6.75% 8.25 - 9% 9 - 9.75% 3.75 - 4.5% 4.5 - 5.25% 6.75 - 7.5% 7.5 - 8.25% 11.25 - 12% 12 - 12.75% 14.25 - 15% South Emerging Asia Lat Global 9.75 - 10.5% Africa Europe Pac Am 10.5 - 11.25% 12.75 - 13.5% 13.5 - 14.25% Tracking Error No. Funds 5 59 105 35 179 Average Tracking error Global funds (179) 5.0% Composite funds (179) 5.0%

Figure 10 : Oliver Wyman: regional and global tracking error data – 5-year horizon.

Above average global funds vs. above average regional composite funds Returns vs. tracking error over 5 years 45%

44% Type Returns T. Error 43% Above avg. global 38% 5.6% 42% Above avg. regional comp. 40% 4.9% 41%

40%

39%

Annualised returns 38%

37%

36%

35% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% Annualised tracking error Global Top composite

Figure 11 : Oliver Wyman: global versus regional risk return chart.

exceeding that of developed nations. The managing a global emerging mandate is a valuations given earnings growth potential are challenge. Especially if you consider that the main reasonable and, as the asset class provides alpha-generating opportunities are at the stock diversifi cation benefi ts, the key long-term level. Evidence suggests the fact that regional incentive is that current emerging market managers are best placed to exploit these stock- capitalisation does not refl ect the global share of level ineffi ciencies. Consequently, a combination activity that these economies represent . of regional specialists should bring added benefi ts The range and diversity of the underlying over a global approach. Independent research by regions and countries means, however, that Oliver Wyman supports this rationale: their

fi ndings were that, on average, regional specialists This paper is issued by NAM UK, a fi rm in combination offer better risk-adjusted returns authorised and regulated by the Financial Services than single global managers. Another argument in Authority. Information and data referenced in the favour of considering regional specialists is that above answers has been taken from sources NAM many of the best global managers are facing UK reasonably believes to be accurate. The capacity constraints, whereas specialists have not contents are not intended in any way to indicate seen their capacity tapped to a large degree. or guarantee future investment results, as the value This is an approach that Nomura Asset of investments may go down as well as up. Values Management have implemented to good effect. may also be affected by exchange rate movements They have developed a structure harnessing the and investors may not get back the full amount advantages of regional specialists, but with the originally invested. Before purchasing any administrative benefi ts of a single point of contact investment fund or product, you should read the for reporting, client servicing and management related prospectus and/ or documentation in order oversight. to form your own assessment and judgment and to make an investment decision. Should you require further information or advice, consult RISK WARNING your advisor. This paper has been prepared by David da Silva, who is employed by Nomura Asset Management REFERENCE UK Limited (NAM UK), the investment 1 The Conference Board and Groningen Growth and Development Centre, Performance 2008 Productivity, specialist in the marketing department in October Employment, and Growth in the World Economies, Productivity 2008. Brief, January 2008 .

EXPERT VIEW Q&A: How to get the best from emerging markets

Fraser Hedgley answers some key questions for trustees about investing in this asset class – and compares current emerging market ups and downs with those from history

Recent falls have highlighted the by Oliver Wyman earlier this volatility of emerging markets. Is an Value of $100 Equity Investment - 20 Years year demonstrated that regional asset class this volatile appropriate for specialists, combined, pension funds? 1800 outperformed global emerging 1600 market managers by 2 per cent I am a product specialist for an 1400 p.a. with no increase in risk. 9 / 11 emerging market fund, so I have to say, 1200 This research vindicated our “Yes!” Leaving flippancy aside, it is an Mexican Crisis view; that greater focus and 1000 asset class appropriate only for those Asian / LTCM Crises depth of research of regional with sufficient time horizon to ride out 800 managers yields outperformance significant volatility and benefit from 600 over traditional global emerging the economic growth expected to drive 400 market mandates. emerging market outperformance over Our own experience in 200 the long term. Emerging markets are researching regional specialist not new to crises. They have recovered 0 managers in Emerging EMEA from the Asian crisis, Russian and Latin America (to Sep-88 Sep-92 Sep-93 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 default/LTCM Crisis, the Mexican Peso Sep-89 Sep-90 Sep-91 Sep-94 Sep-95 Sep-96 Sep-97 Sep-07 Sep-08 complement Nomura’s Asian Crisis, and bounced back strongly. [See expertise) has revealed the MSCI EM MSCI World Chart 1] Admittedly, this crisis is depth of insight regional bigger, but the pattern remains. managers can achieve. Favourable demographics, increasing Chart 1: shows the value of $100 invested over 20 years to Gratifyingly, the performance of wealth (coupled with growing demand) 30 September 2008 in developed and emerging markets. After each the managers Nomura accesses and increasing fiscal and monetary crisis highlighted, the long term outperformance of emerging in each region has been strong. responsibility (with some notable markets was curtailed, and then recovered. exceptions) will drive corporate earnings as they have in the past. The Risk Warning: This article has been prepared with the return premium that should result from this Quantitatively, peer group analysis of assistance of Fraser Hedgley, who is employed by Nomura Asset long-term positive story is available to emerging market managers suggests the Management UK Limited (NAM UK). investors able to tolerate short to medium median manager has outperformed over time Nomura Asset Management U.K. Limited is authorised and term volatility. (in stark contrast to some more developed regulated by the Financial Services Authority. Information and markets). This suggests that the talent to data referenced in the above answers has been taken from Should investors seek active or passive capture alpha exists, although the spread sources NAM U.K reasonably believes to be accurate. The investment in this asset class? from upper to lower quartile managers is contents are not intended in any way to indicate or guarantee future investment results as the value of investments may go large, so it is important to choose the “right” down as well as up. Values may also be affected by exchange Again, I have a vested interest here! But I manager. rate movements and investors may not get back the full amount genuinely believe investors should only take originally invested. Before purchasing any investment fund or active risk in the asset classes where it is What is the best way to seek alpha in product, you should read the related prospectus and/or most likely to be rewarded; where there is emerging markets? documentation in order to form your own assessment and demonstrable inefficiency and where investor judgment and, to make an investment decision. talent exists to capture it. Emerging market From the previous argument, you may deduce equity is one of those asset classes. that I believe in fundamental active By Fraser Hedgley, CFA Anecdotally, much of the day-to-day volatility management of this asset class. Nomura, of Nomura Asset seen in individual emerging stocks can only recognising the innate difficulty of researching be ascribed to over-reaction to newsflow and 25 politically, geographically, linguistically Management UK Limited (to an extent) illiquidity. Investors focused on and culturally diverse emerging markets (let fundamental value should be able to capture alone frontier markets), built global emerging market mispricing and profit from it. coverage using regional specialists. Research

ENGAGED INVESTOR WWW.ENGAGEDINVESTOR.CO.UK NOVEMBER/DECEMBER 2008 29 FINANCIAL TIMES MONDAY OCTOBER 20 2008

Emerging ions beat the crash markets 350 pension schemes accounting basis, by falls In measured by lAS 19 accounting standard liability values, so company still in balance sbeet liabilities will not have increased by as much as was perhaps favour expected," said Deborah Cooper, principal in Mercer's By Ruth Sullivan retirement business. The robust lAS 19 picture Institutional investors stili will allow companies with a bave a keen appetite for September 30 year end to emerging markets in spite of avoid reporting a deteriora· volatility and heavy falls tion in tbeir fWlding position across stock exchanges this in their acconnts, potentially year. lessening any pressure to Three·quarters of northern accelerate the closure of European investors are plan· schemes. .ning to raise exposure to Although some might see emerging markets equities this as an unduly optimistic over the next tm'ee years, picture, Ms Cooper argued according to a survey by that if double A bond yields Nomura Asset Management 17 per <:eDt of their the iBoxx AA index. Accord· feU in the future ibis migbt UK. 11 equities of Sep ing io Mercer, as of Septem· well be accompanied by ris· "Many institutional inves 30. bel' 30, 89 per cent of the ing equity markets. tors are looking at emerging lCCmingly bl2arre pic· bonds in this index had been However the buy·out defi· markets as a long·term stra· lerges beca ,under issued by financial institu· cit, the aggregate addillonal tegic investment," said 19 accounting regu. tions and, as bank default sum FTSE 350 companies David da Silva, who runs , scbemes use the .1sk hit unprecedented lev· would need to provide to Nomura's regional emerging I double A corporate els, yields ballooned io above persuade insurers to take market strategy. to discount the net 9 per cent for five·year over their assets and liabili· "These countries in gen value of their future paper, from a liltle over 6 ties, jumped to £l92bn at the eral continue to grow faster ~. per cent a year eal'ller. end of September, according than their developed coun· Iver, many schemes "Recenl eqnity market to Mercer, from a low of terparts, and although they eir discount rate on falls have been offset, on an £110bn in November 2007. are facing difficulties in the current Climate, high sav ings rates and strong fiscal positions remain a feature of many emerging markets," he added. LItual funds suffer outflows Out of the 20 institutions surveyed, a quarter will raise their emerging market said one buy Bide Lewbart acknowledged net houses," said Brad Hintz, exposure between 4·l0 per :adel'. outflows from equity funds brokerage analyst at Sanford cent, while the rest have lber 2007, as well as for both September and the Bernstein, pointing out that more modest plans of y and July 2008, third quarter, but termed any vulnerability at Merrill Increasing exposure by up to sinlilar vohunes of them "modest". Lynch and Wachovia creates 4 per cent. vestal' selling. Aside from tbe pressure on uncertainty for a vasi POI" Investors, whose combined ,mparison to the assei values, the market col· tion of the US retail sales managed assets total €l60bn king market drop, lapse may bring about a force. Merrill Lynch declined (£I24bn, $2t5bn), were also I from mutual fnnd purge of another SOl·t to the comment. moving towards using more Jes were muted. retail Investment indusiry. Mr Hintz said: "The last regional specialists ratber .Iumes are up and As brokerage firm share big move of this sort was than general emerging mar· I are concerned, but prices weaken, so do the during the scrutiny by ket fund managers in search king to our repre· stock·based incentives that [former New York attorney of outperformance. !!s most ended up tie brokers to companies, generalI Eliot Spitzer, when In times of global crisis, vhere they were. We driving many to stronger brokers told their customers: investors' appetite for risk lVesting for the long houses, or to start or join 'I don't trust this company tends to decline and move aid Linda Wolohan small Independent firms. any more. I want to take you from more risky and less Iiq· uard Group. "This is a big deal. It's the people away to a safe place uid stocks ill emerging mar· Rowe Price, Brian breakdown of the wire· my own.'" kets towards safer, more liq· uid assets.

Calming nerves ""I equity team America. He was previously r Stearns Asset at Nuveen Investments In a ent. headed by senior business development icman who and product management senior managing role. ---' ~----' ---'- Chapter 3

Expert View: Emerging Markets

here is no one catch-all definition of an global economic growth and are home to Temerging market. However, it would 80 per cent of the world’s population. typically be associated with a poorer-than- developed world economy, more reliance on EMERGING MARKETS AND basic industries and agriculture than PENSION FUNDS services and technologies, but with an The high rate of economic growth in established and reasonably liquid stock emerging markets is expected, over time, to exchange, open (at least partially) to foreign lead to higher earnings growth for investors, and a functional financial, legal companies in those regions, as compared to and regulatory framework in place. developed market companies. Greater The most widely used emerging market corporate earnings should lead to greater index provider, MSCI, considers market stock market returns. Thus the prospect of accessibility, security, suitability for long term returns in excess of bonds and investment and sustainable economic even developed market equities, is attractive development in determining which markets to many pension funds. are “emerging”. They will typically engage Emerging markets exposure can also help in a wide consultation before they change to diversify risk in conjunction with other the classification of a country to either asset classes. Although the markets in “developed”, “emerging”, or “frontier”. isolation are volatile, historically they have Regardless of the definition used, exhibited low correlations to developed emerging markets are characterised by markets and thus aid diversification. relatively rapid economic growth, growing Investment in emerging markets requires a urban populations and industrialisation. tolerance for equity risk, foreign currency risk They may also have higher volatility than and, potentially, some liquidity risk. As noted developed markets, some capital controls above, emerging markets can be volatile and and stock markets with lower liquidity. They over some periods are likely to underperform are also associated with a high degree of cash and bond yields. Therefore, an investor market inefficiency. should have a long investment time horizon Emerging markets collectively represent to increase the probability of making good more than 10 per cent of the investable any short term falls. world market, as measured by MSCI; a A defined benefit pension fund with such greater proportion than Japan. They tolerance could invest in the hope of contribute approximately 50 per cent of capturing the expected long term risk

56 ENGAGED INVESTOR: Trustee Handbook 2009 by Fraser Hedgely Nomura Asset Management

premium of emerging markets. However, we mandates, a single, global mandate remains strongly advise pension fund trustees to seek the most popular method of exposure. suitable expert opinion before deciding to Pooled or segregated investment vehicles invest in emerging market equities. are also available. Pooled funds are simpler A defined contribution (DC) pension fund and practical for smaller funds. Segregated may offer an emerging market fund as an accounts offer greater flexibility and may be option for members or as part of a wider, cheaper for large funds. For emerging prescribed investment strategy. The long market mandates, a pooled fund vehicle is term return characteristics of the asset class favoured by many pension funds to avoid may appeal to members sufficiently far from the considerable administrative burden of retirement but, as with all DC investment obtaining permissions to invest in a range of funds, the risks must be clearly emerging markets. I communicated to members to allow them to make knowledgeable investment choices. QUESTIONS FOR YOUR ADVISER OBTAINING EXPOSURE Advisers should assist you with: Some pension funds permit their global Assessing your risk tolerance and whether or equity managers to invest in emerging not an exposure is appropriate; markets opportunistically. However, this The timing and size of any investment; approach is not ideal. Many pension funds The pros and cons of specialist regional therefore appoint a dedicated emerging emerging mandates; markets manager. Which investment manager(s) to appoint. Some funds go further, and appoint Ask your investment managers about: managers to specialist mandates within the Their team’s experience and track record in emerging markets, such as Latin American emerging markets; equities, Emerging Asia equities or BRIC Market coverage: is the manager a specialist in (Brazil, Russia, India China) equities. Such one area with only basic coverage elsewhere?; specialism has appeal given the difficulties of Fees (typically higher than for developed managing a mandate across emerging market mandates); markets so differentiated by geography, Assets under management. Large assets under climate, language, currency, politics and management can restrict an emerging market regulation. However, due to the complexity of manager from implementing investment ideas. constructing global exposure through regional

ENGAGED INVESTOR: Trustee Handbook 2009 57 EMERGING MARKETS FOCUS

Emerging markets: divide and conquer

ndependent research conducted by the consultancy firm Oliver IWyman on behalf of Nomura Fraser Hedgley explains why focusing on specialist Asset Management proves that focusing manager skill on separate, regional portfolios in the emerging market space can regional portfolios leads to a significant alpha premium. There bring pension funds their much needed extra alpha are, however, difficulties in conquering the global emerging world by dividing mandates among specialists within emerging EMEA, Asia and Latin America. This article addresses these two main points.

Regional specialists in emerging markets outperform In February 2008, Oliver Wyman completed research that investigated the potential of regional specialist manager combinations1. They found that, net of fees, an average of the regional specialists in the EMEA, Asia and Latin America regions, combined (at regional market weights) to form a synthetic “global” Figure 1: Annualised returns plotted against tracking error for above-average global emerging market strategy, outperformed the average funds (blue dots) and for composites of above-average regional managers (red dots). Source: global emerging market (GEM) Bloomberg, MSCI, Nomura, Oliver Wyman analysis. Note: Above average funds are defined as funds manager in six of the seven calendar comprised of managers with above average returns over the defined time period years to end 2007. Moreover, as demonstrated in managers operate on a generalist Clearly, a fundamental manager Figure 1, the above-average global basis, attempting to cover trying to understand each market specialist managers (combined) countries as diverse as Peru, South and select stocks within them faces managed to outperform their global Africa, Taiwan and Egypt. A mere an immense burden which a peers by 2% per annum over the five glance at the emerging world in regional approach to coverage years to end 2007 yet had a lower total highlights some significant would help to overcome. This is tracking error. challenges to this approach: particularly true if one believes that Should we be surprised? No. Benchmark of 785 stocks2 the greatest inefficiencies in these Large institutional investors and c14,000 stocks off-benchmark markets occur at individual stock level. advisors have long warned us that, 25 countries, 26 currencies, by employing generalist managers, 60+ languages GEM managers have struggled to we leave alpha on the table. Geographical spread of markets outperform Yet, while developed world Varied accounting and reporting Emerging markets are regarded as balanced and multi-region mandates practices among the most inefficient equity are now rarer, in contrast the vast Country-specific factor influence markets in the world. However, majority of emerging market on equity performance partly as a result of the

44 www.europeanpensions.net EMERGING MARKETS FOCUS

aforementioned challenges, over managers including (1) Potentially The final point is relevant to all but the seven years to end 2007 (the higher fees and administration the largest investors; those who longest period for which there is a costs; (2) Greater governance and need to appoint managers via meaningful sample size), the monitoring burden; (3) Difficulty of pooled fund mandates. Funds average global emerging market selecting good regional managers, pooled at a regional level, governed manager underperformed the and; (4) Benchmarking issues. by UCITS regulations, will suffer MSCI Emerging Market Index net of The first two points are inherent from structural underweights to the fees. Indeed, the upper quartile when increasing the number of mega-cap stocks such as Gazprom, manager only succeeded in individual managers employed. China Mobile and Petrobras, since matching the index return. Regional The third point is a difficulty that they form more than 10% of the specialist combinations fared Nomura will readily attest to. Known regional indices. Individual stock better; a composite of the average for our emerging Asia expertise, we holdings are limited to no more than upper quartile regional managers first built a single global emerging 10% of a fund under UCITS. outperformed the average upper market product in 2006, using the The largest institutions, with in- quartile global manager by 2.4% p.a. regional specialist skills of house manager research expertise, over the seven year period, as Charlemagne Capital (in Emerging will no doubt find these difficulties illustrated in Figure 2 (below). EMEA) and Gartmore Investment surmountable, and the effort The most vital conclusion of this Management (in Latin America). involved can be amply rewarded. analysis is as follows: the active Since then, it has been an ongoing Other investors should seek a single investor in emerging markets must challenge (for the purpose of product accessing the skills of be confident that he can choose an prudence) to identify skilled reserve regional specialists. upper quartile global emerging managers in each region that To conclude, specialist emerging markets manager or must employ a remain open to new business. market managers combined to give regional specialist approach if he Nomura has had to bring global coverage have, on average, expects to outperform. considerable resource to bear on outperformed GEM managers. This assessing managers in the EMEA reinforces the widely accepted idea Appointing regional specialists and Latin America regions. The that specialist managers with more The lure of additional alpha through ability to devote this resource must focus and resources to devote to a a diversified, regional manager be a key consideration for any particular area of investing will structure is great, but there are investor undertaking regional outperform generalists. Based on barriers to appointing specialist manager selection. this evidence, for large investors with sufficient resources, or smaller investors with access to cost- MSCI Emerging Markets Index, 30 June 2008 effective fund of funds or similar products, seeking regional specialist emerging market managers should be strongly considered.

(1) Oliver Wyman's Emerging Market Product Analysis, 2007 Update. A summary of the research is available from Nomura (2) MSCI Emerging Markets Index 30 June 2008

WRITTEN BY FRASER HEDGLEY, CFA, GLOBAL EMERGING MARKETS PRODUCTS SPECIALIST, NOMURA

Figure 2: Seven year annualised returns of global emerging market managers, ending Sponsored by 31 December 2007. Source: Bloomberg, MSCI, Nomura, Oliver Wyman analysis. MSCI EM return is the return (including net dividends) of the MSCI Emerging Markets Index

www.europeanpensions.net 45 54 NomuraADV Sep/Oct08:HSBC 10/9/08 12:21 Page 54

EXPERT VIEW China and India – is it time to invest now? Peter Jenkins explains some of the major factors that are contributing to the development of China and India as powerful, emerging markets

I hear conflicting reports about China and India demand. The increasing development of the – some say this is the ideal time to invest in middle class in both countries means that there the region, others say that it’s already over- is more consumer spending. Mobile telecoms are valued. Who’s right? also another good sector and China Telecom is particularly strong. All markets are fighting a slowdown at the Shares in companies that rely on exported moment and that affects India and China just goods are less desirable. Global growth is falling, like everywhere else. However, we have seen which means that demand for exports may fall. between 15 and 19 per cent earnings growth in Also, we worry about financial institutions and India and 25 per cent growth in China this year. need to be careful when investing in those. Inflation is a concern in both countries, although we are now seeing some pullback on What are the longer-term expectations for this that in China at present. But China’s economy region – is this a good place to put my scheme’s has slowed and its interest rates are also rising. money for the next ten years? Overall, although there are risks to the markets in the short term, we would advocate a long We think so. There will be stronger growth in term investment horizon which should put short both China and India than in more developed term fluctuations into perspective. markets. Companies will exploit that – and we Much attention has been given to the eye- will see good business growth. The long term catching drops in China’s A-share market, outlook is good, although you might not see which lists shares in the Chinese currency, growth week in week out, or even on a monthly Renminbi, and is only open to Chinese basis at the moment. investors. Pension funds from the UK therefore The trade and business links in all BRIC won’t have been able to invest in A-shares and (Brazil, Russia, India and China) show won’t have been affected by the falls on that companies beginning to launch products to market. The B-shares listing, which trades in other, foreign markets. There is significant foreign currencies and is available to overseas What exactly does ‘investing in China’ mean? domestic demand. People will be buying their investors, has seen more muted performance Am I buying buildings, stocks and shares, first ever car in China or India, for example. and hasn’t been affected to the same extent. roads – what’s included and what types of There are lots of opportunities and it will be hard investment are particularly strong at the to stop these economies from accelerating. What are the main risks and rewards moment? associated with investing in China and India? Peter Jenkins is employed by Nomura Asset Management We invest primarily in listed equities in these U.K. Limited (NAM UK), a firm authorised and regulated by Over the long term there will be plenty of regions – the bond market is under-developed the Financial Services Authority. Information and data growth, which will reap big rewards. There is in China and also to a lesser extent in India. referenced in the above answers has been taken from sources NAM U.K reasonably believes to be accurate. The good domestic demand, strong economic India has Asia’s oldest stock market, dating contents are not intended in any way to indicate or growth and good earnings growth. And, back to the 19th century and so that is a very guarantee future investment results as the value of although there are some risks to that growth in different set up from China’s A-share and B- investments may go down as well as up. Values may also be the current climate, in general that story share structure discussed see above. Across affected by exchange rate movements and investors may not remains unchanged. both markets, we like to see growth in get back the full amount originally invested. Before Political risk is present in China as it is still a necessities such as infrastructure (investing in purchasing any investment fund or product, you should read one-party state. But that one party has a strong essential developments such as roads or the related prospectus and/or documentation in order to handle on the domestic and economic situation. airports). India has over $1trn of infrastructure form your own assessment and judgment and, to make an They could mis-handle inflation, but that’s development planned over the coming years. investment decision unlikely. In India, political turmoil is always China operates with closed capital accounts present. There will be elections within the year – meaning that Chinese citizens’ money is not By Peter Jenkins, and the ruling coalition has only just survived allowed to leave the country. As earnings of Nomura Asset recently. We are seeing economic initiatives and growth has increased and the money can’t leak populist measures that link to an upcoming out of the country, that extra capital has fuelled Management UK Limited election. There are no immediate concerns and a liquidity boom. That has meant that other no significant risks associated with these areas for investing where we’ve seen good changes. potential include those involving domestic

54 SEPTEMBER/OCTOBER 2008 ENGAGED INVESTOR www.globalpensions.com Sponsored article September 2008 29

many outside observers of the oil market, such as equity investment managers, were surprised Emerging markets in by the immoderate price rises. An uncertain future As oil prices and other commodity prices fed through and impacted earnings expectations the grip of inflation: across all industries, investment managers faced the prospect of positioning portfolios in a more volatile and uncertain climate. The following articles by Gartmore Investment Management, Charlemagne Capital and Nomura winners and losers Asset Management Singapore highlight issues which are pertinent to each of the specific regions in which they invest for the Nomura Asset Man- agement GEM strategy: Latin America, EMEA and emerging Asia respectively. They have all had to contend with inflation and commodity David da Silva, CFA is price rises in their regions and it is apparent that, head of GEM strategy although in many ways the forces driving infla- at Nomura Asset tion are global in nature, regional knowledge and Management U.K. expertise are key in understanding where the Limited investment opportunities are best located. It is crucial that within this environment managers are able to target companies that can increase or maintain their margins and so have valuations solidly underpinned by earnings. Chart 1: The impact of rising food prices on headline inflation worldwide David da Silva considers how rising oil and food prices are impacting upon emerging markets and introduces this four-page special focus on emerging markets

Inflation has provoked alarming headlines across nomic and political landscapes of the developing the world. Emerging markets are bearing the world. This has recently flared up in many well brunt of the inflationary pressures. In this feature publicised protests across the emerging world. we consider the causes of inflation, its exagger- Fortunately, there are signs that soft commodi- ated impact on the emerging world and opportu- ties and energy costs may have peaked in the Food inflation Contribution of food inflation nities for investment managers. Inside this special short term, and so the worst may be over. Not- to headline inflation (2007, yoy) four-page pull-out section three emerging market withstanding, there remain wide ranging con- Over 75% 50-75% specialists examine the issues facing Emerging sequences of these price changes. Whilst, for 25-50% <25% Asia, EMEA and Latin America. most, the effects of inflation are negative, some No data Chart 1, produced by the Financial Times countries are well placed on an energy and agri- (FT), highlights the impact of rising food prices cultural footing to weather and even profit from Source: Financial Times, Published April 13 2008. Last updated: May 6 2008 on headline inflation across the globe. Their this new environment. analysis makes it clear the impact of food infla- Illustrating this, Chart 2 highlights the first Chart 2: First round impact of commodity price changes on trade balance of selected tion is more severe in the developing world than round impact of commodity price rises on trade countries, 2007 (contribution to change in trade balance in percent of GDP) it is in developed countries, because consumers accounts. What is apparent is the diversity of Bangladesh in developed countries spend a significantly results across these emerging countries. Some, India lower portion of their income on food than their like Bangladesh and India, will struggle, while Pakistan Georgia developing counterparts. As an example, house- others, like Saudi Arabia and Argentina, are well Armenia holds in the US and Europe on average spend placed. Understanding these broader economic Turkey Thailand Non-energy about 10% to 15% of income on food, while this impacts is crucial in making investment deci- Philippines Energy Egypt number rises to 30% in China and could be as sions on a company level. Net impact Ukraine high as 80% in countries in Sub Saharan Africa. China In addition, the FT makes the point that as Challenging environment Uruguay The articles which follow in this sponsored fea- Poland consumers in developed countries consume more Mexico processed food than fresh food, the so-called ture highlight that, despite the profound impact South Africa “farm value” of food prices is relatively small. In of inflation in the developing world, for informed Chile Zambia other words, the costs of processing and trans- investment managers there are indeed areas Brazil portation constitute the majority of the food where opportunities exist to make money and Colombia Indonesia article’s price, so that price fluctuations in the deliver returns. What is clear is that the emerging Peru underlying agricultural commodity are diluted. markets investment landscape has changed, Russia Iran, I.R. of On the other hand, in emerging markets, the making what is already a very challenging man- Argentina “farm-value” of food is much greater, as the pop- date even more complex. As an example of this, Malaysia Kazakhstan ulations rely more on unprocessed staples such commodity prices have proven very difficult to Saudi Arabia as wheat and rice. Consequently the rise of the call and factor-in accurately in valuation models. underlying agricultural commodity prices has a The extent of price rises was well in excess of the -2 -1 0 1 2 3 4 5 6 far more profound impact on consumers. wildest estimates at the start of the year. This, in Source: IMF World Economic Outlook, April 2008: Housing and the Business Cycle turn, has affected country fortunes, industries Food paradox and sub-sectors in different ways and ultimately Chart 3: Energy and metal prices and metal consumption growth This sets the scene for a paradox. On average, in impacted company valuations considerably. the developed world, households consume more Chart 3 was published in the IMF World Eco- food than in emerging countries, but this consti- nomic Outlook earlier this year, and highlights Brent crude oil futures prices as of 25 March 2008 150 tutes less of their household expenditure than the expected oil price range over the twelve (US dollars a barrel) it does in developing countries. In short, they months, with the various confidence intervals Futures 120 eat more, but it costs less. So rising food prices associated with the forecasts. On 25 March this 50% confidence interval 70% confidence interval mean inhabitants in the emerging world become year, participants in oil futures markets put the 90% confidence interval poorer on a relative basis compared to those in future value of oil around US$100 per barrel, a 90 developed nations. pricing that suggested that there was less than This outcome relating to food inflation has a 5% probability of spot oil exceeding $135 per 60 similar parallels in fuel prices, as fuel is also a barrel over the short term. Yet on 4 July, the price substantial component of emerging countries’ touched $147. Significant, experienced players in 30 Consumer Price Indices. Together, food and fuel the oil futures market in March were willing to 2006 07 08 Mar 09 inflation have had a massive impact on the eco- supply oil at less than $100. Small wonder that Source: IMF World Economic Outlook, April 2008: Housing and the Business Cycle 30 September 2008 Sponsored article www.globalpensions.com EMEA stock selection in an inflationary environment: Uralkali case study At the start of 2006 came the first ideal, so investigating the market signs of significantly rising food further we found that there was prices across the globe. This was a significant Russian producer particularly evident in emerging of potash called Uralkali. Cru- economies where the impact on cially, potash fertiliser production personal consumption was most was the sole business of this com- conspicuous. pany. Its reserves are located in the The causes were increased Verkhnekamskoe Deposit, which is demand for food across the the second-largest known potash world, a result of numerous fac- deposit in the world, reported to tors including increasing levels of contain in excess of 3.8 billion affluence, continued urbanisation tonnes of potash ore. of emerging populations, which So, we analysed the company has drawn production away from fundamentals, held several dis- rural areas and farms, and supply cussions with management and disruptions (drought, storms etc). had on-site meetings at the com- In addition, and something which pany. Demand for potash remains was to become more and more of a strong. The market for potash is factor, was the increasing amount relatively tight, with high barriers of land dedicated to bio fuel pro- to entry, and this has sent the price duction. of fertiliser sharply higher. Ural- So with demand growing and kali’s sales are tied to long term food in short supply, it was clear to contracts, providing low cashflow us that the rising price trend was set not envision the steep price rises we highlighted more generally in the volatility, but as these contracts to continue for the next few years, have seen on soft commodities such CRB Spot Index chart (Chart 1). fall away, it gains exposure to the though it is fair to say that we did as rice, wheat and other staples, as So how did we at Charlemagne higher spot price, thus enhancing Capital, as stock pickers, interpret earnings growth. Chart 1: CRB spot index foodstuffs – price index from 5 August 2003 to 5 August these developments and respond to At the same time, it plans to 2008 (weekly) generate alpha? An obvious point increase capacity by 30% by 2010. 450 of call given this backdrop would We were satisfied that the company have been to invest in food pro- fundamentals stacked up well, 400 ducing companies; however, these growth prospects were good, man- have not always been in a posi- agement was experienced and effec- 350 tion to pass on rising input costs tive and the industry background and so in an inflationary envi- was favourable. We then considered

300 ronment would see their margins how the share price rated against shrink and their valuations under this background. Running our medium term pressure. With numbers and cash flow analysis, it 250 farmers demanding more from was clear the stock was attractively their land and trying to increase priced and if indeed the market 200 2003 2004 2005 2006 2007 2008 yields, it was clear that there for potash continued to grow, then Date would be increased global demand Julian Mayo is an Uralkali was ideally positioned High 444.19 (1 July 2008) Low 231.26 (5 August 2003) Last 403.01 for fertiliser. investment director at in the industry to add significant Source: Thomson Datastream Following preliminary investi- Charlemagne Capital shareholder value. gations with our local and inter- Chart 2: Israel Chemicals USD stock performance national contacts, we realised How did this strategy 1,200 agrichemical producers had indeed play out? already started seeing price rises Firstly, as we are all no doubt 1,000 and that it was a challenge to find aware, food prices have continued 800 any that were still offering good to rise – this has been a key trend. 600 value. Looking more closely at the Secondly, food producers in a bid fundamentals of the business we to improve yields have demanded 400 realised potassium carbonate, also more fertiliser, and in turn the 200 known as potash, which is a key price of potash has risen sharply. 0 component in most fertiliser mixes, Recently, we have seen potash spot 1 Jan 2006 30 June 2008 was in short supply and evidencing prices for Asia delivery topping the a strong price rise. $1,000 per tonne mark; this is more Israel chemicals Ltd Our analysis revealed there were than five times the level achieved Source: Thomson Datastream few reliable potash producers, and three years ago. Data based to 100 as at 1 Jan 2006 that the industry dynamics looked Finally, mining companies pro- strong. We initially targeted our ducing potash, like Israel Chemicals Chart 3: Uralkali USD stock performance investment via Israel Chemicals, and Uralkali, have seen sharp price 1,200 a broadly diversified industrial escalation over the past few years,

1,000 chemicals producer, which among as shown in Charts 2 and 3. many different production lines Although we pride ourselves on 800 was also a key global potash pro- our stock picking ability, the case 600 ducer. We liked this company on study above highlights that we 400 a fundamental basis, and, having target our stock picking opportu- visited it, were happy with manage- nities harnessing broader industry 200 ment and its business strategy, and, and market information: consid- 0 most importantly, the valuation ering trends, seeing suppliers, 1 Jan 2006 30 June 2008 according to our calculations was customers and competitors. Our still favourable. extensive regional experience and Uralkali Nonetheless, as a diversified depth of research enable us to cap- Source: Thomson Datastream chemical company this was not a italise on opportunities to deliver Data based to 100 as at 1 Jan 2006 pure potash play, which was not added value to our investors. www.globalpensions.com Sponsored article September 2008 31

inflation policy tool. However, as crude oil and food prices rallied – the former doubled from July 2007 to June 2008 – ballooning subsidy burdens Inflation in Asia: not just a have started to threaten fiscal stability. Conse- quently, Asian governments have been forced to change their policy stances and allow fuel (and to some extent, food) prices to rise as the market moves. China, India, Malaysia, and Indonesia monetary phenomenon have raised retail fuel prices significantly in the second quarter of 2008, while accepting the risk of aggravating social tensions. Other governments have taken a more conservative approach and have increased subsidies. Such fiscal policy reverses have prompted some monetary authorities in Asia to change their policy stance. In an environment dominated by the financial market turmoil and the risk of a possible global economic slowdown, Asian central banks, with the exception of the People’s Bank of China, had maintained a bias towards monetary easing until the first quarter of 2008, or, throughout the period when fiscal policy changes were taking effect. From the second quarter, they have started to tighten Hiroyuki Nakai is a senior their monetary policies in an effort to contain economist at Nomura the inflationary expectations and to halt cur- Asset Management rency depreciation by maintaining confidence Singapore in their monetary policy. But, since the downside “Inflation is always and everywhere a monetary fixed price systems for fuel, while other govern- economic risk is still a real threat, some Asian phenomenon.” On the surface, this famous asser- ments are paying subsidies or reducing indirect authorities are wary of over-tightening their tion by Professor Milton Friedman in the 1970s taxes. Retail prices of wheat flour and some other monetary policies. In short, they are willing to still seems valid in Asia today. Consumer Price cereals are regulated in India, and most Asian bear higher rates of inflation as long as they look Indexes (CPIs) are now increasing rapidly and governments have a subsidised rice distribution relatively short-lived. monetary authorities are raising rates to counter system. the inflationary pressure. However, just how true Regulatory pricing systems for food and Investment strategy in an is Professor Friedman’s statement? energy worked well under a low-inflation envi- inflationary environment In the case of the 1970s, the oil price shock – a ronment and even at the initial stages of this cur- Although we are principally stock pickers, we supply side factor – was the trigger for an infla- rent inflationary cycle. In another words, fiscal incorporate macro factors in our stock selection tionary spiral, and price increases extended measures in Asia have been used as a major anti- process. In effect, how will inflation impact on across almost all goods and services amid the earnings of any one stock? This integration of Chart 1: Consumer price inflation 2000-2008 strong demand-side pressure. Inflation accom- bottom up and top down factors results in more panied a general price level increase, and mon- Percent, year on year robust investment decisions at the stock level. etary policy tightening was effective in calming 12 Our view that inflationary pressures will rise inflation expectations and easing the demand- over the long term certainly makes things more 10 side inflationary pressure by cooling down eco- Emerging economies Advanced economies challenging. However, it also provides us with nomic demand. That is why Professor Friedman 8 opportunities to make money for our clients. described inflation as a “monetary phenomenon”. 6 For example, we are overweight selected

This current outbreak of inflation in Asia is 4 resource and basic material stocks such as not the same as in the 1970s . For now, much of the diversified miner BHP in Australia and the inflationary pressure is still concentrated 2 the Korean steel company, POSCO. In the long in the form of food and fuel price increases, 0 term, these stocks will benefit from continued and is more pronounced in emerging coun- strength in prices for commodities. We see that tries than developed countries, as highlighted the commodity bull run will continue for the in Charts 1 and 2. Although the second-round Q1 2000 Q4 2000 Q3 2001 Q2 2002 Q1 2003 Q4 2003 Q3 2004 Q2 2005 Q1 2006 Q4 2006 Q3 2007 Q2 2008 medium term, following years of under invest- Date effect of higher food and energy prices is a con- ment in the sector. cern, namely higher wage claims, prices of other Source: Datastream, Nomura However, we must also be cogniscent of what, goods and services have not yet seen any sig- in our view, could be excessive euphoria on infla- nificant increases. In this context, the current Chart 2: Commodity prices (2000-2008) tion beneficiaries or analysis on the winners and inflation outbreak in Asia (and elsewhere) is so January 2000 = 1 losers that may be faulty. As such, we are actually far still limited to just a change in relative-price 600 underweight energy stocks. We feel valuations are levels. Of course, tighter monetary policy is 500 excessive and optimism on continued sharp rises useful for containing inflationary expectations. Oil Food in oil prices is misplaced. Notwithstanding, it pays But a cooling down of the economy cannot fix 400 to be discerning and look within the broader sec- the rising food and energy prices since demand 300 tors and view the dynamics of the constituent sub for these commodities is less price sensitive. 200 sectors. As an example, we are optimistic about Even worse, monetary tightening could impede the prospects for oil explorers, while we think oil structural adjustments in the economy to fit with 100 refiners are not well placed to be able to pass on the relative price increases of food and energy. 0 input price increases. Another crucial issue in parts of Asia is We are also overweight the Philippines. This 2000 2001 2002 2003 2004 2005 2006 2007 2008 concern over social stability. Compared with may seem paradoxical given it is a major importer Date advanced economies, per capita GDP levels are of commodities and therefore a loser from higher generally lower in Asia while these countries Source: Datastream, Nomura inflation. However, it is also a major exporter of often have wider income disparities as well. This people – 10 million at last count. Many of these are means that recent food and energy price rallies Chart 3: Food and energy as a proportion of CPI indices highly skilled and are increasingly employed in threaten the daily purchasing power and well- Food weight in CPI indicies Energy weight in CPI indices Middle Eastern countries buoyed by oil revenues. being of huge numbers of low income people. India 60.2% Indonesia 15.2% Remittances back to the Philippines are running Philippines 46.6% India 14.2% Due to the prevalence of such social structures Indonesia 45.3% Malaysia 13.8% at over US$1.4bn per month and providing a sub- in Asia, the weightings of food and energy in the Vietnam 42.7% Philippines 13.6% stantial fillip to the economy. Thailand 36.1% Thailand 9.7% Consumer Price Indexes are relatively high com- China 33.0% S. Korea 5.9% As highlighted above, a fundamental aspect pared with developed Western economies, as Malaysia 31.4% Singapore 5.3% of our stock analysis is to isolate companies that Hong Kong 26.9% China 5.0% are best placed to maintain or improve margins highlighted in Chart 3. Taiwan 25.1% Taiwan 3.7% Hence governments have recognised infla- Singapore 23.4% Hong Kong 3.6% by passing on input cost increases to their cus- tion to be a social issue too, and are therefore uti- S. Korea 15.9% Vietnam N/A tomers. To execute this effectively in a universe lising fiscal measures. For example, China, India, 0% 10% 20% 30% 40% 50% 60% 70% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% as diverse as emerging Asia requires regional Malaysia, and Indonesia have adopted (de-facto) Source: CEIC, Nomura Asset Management U.K Ltd experience, extensive resources and deep company research. 32 September 2008 Sponsored article www.globalpensions.com Oil price rises: impact on Latin America by the cost of extraction. In Latin greater the incentive for techno- America, preliminary findings logical innovation and substitu- on the continental shelf located tion. According to energy analyst off the east coast of Brazil sug- Daniel Yergin, the price outlook gest there is significant potential will vary according to the degree for the commercial extraction of of technological optimism or geo- oil from the Campos and Santos logical pessimism. basins. Brazil barely features in international rankings of major Investment strategy energy exporters. If recent finds Gartmore’s Emerging Markets are proven to be viable, the country Latin American funds are posi- could be listed as the holder of the tioned by virtue of their holdings eighth largest oil reserves in the to take advantage of the new era in world. However, the full potential developing energy sources, particu- of these fields will depend on the larly deep-water oil exploration. In ability of companies such as Petro- comparison to integrated oil compa- bras of Brazil, Repsol YPF of Spain nies, deep-water oil exploration and and BG of the UK to overcome production companies offer more the practical issues that surround sustained benefits over the oil cycle. the extraction of oil and gas from Drilling for oil in depths greater beneath 2,000 metres of sea and than 400 metres demands complex 2,000 metres of salt rock. These and costly technological solutions, include operating in conditions of including the use of floating drilling extreme cold in deep water, heat in platforms. rocks within the earth’s crust and Our holdings span various facets In 1996, the economist Roger Bootle tially demographically-driven. at high pressure. of energy development and include published a book titled The Death The world’s population has more Interest in Petrobras’ discov- Petrobras, widely regarded as a of Inflation. At the time, the global than doubled since 1950 to 6.6 bil- eries has contributed to the domi- leader in deep-water exploration, economy was expanding, and the lion people, yet some key energy- nant role that the company plays and other related companies, such process of globalisation was helping utilising technologies, like the within the benchmark MSCI Latin as Usiminas, the producer of steel to keep costs down while produc- combustion engine, have not America Index. Petrobras alone plate, and Tenaris, the manufac- tivity increased. Now inflation is been challenged in the mass accounted for 18% of the index at turer of seamless steel tubes that back. Oil reached a new record over market. The aspirations of mil- the end of July; part of a scenario carry oil and gas, plus Confab, the US$147 a barrel in July, and higher lions of consumers, particularly in where energy stocks constitute maker of natural gas pipelines. energy costs are feeding through newly emerging economies, have almost one quarter of the value of Perhaps, more critically, we global production chains. While the prompted a surge in demand for the entire index. This has obvious have identified the ‘supply crunch’. rising trend reversed sharply in late energy. While the US has 450 cars implications in the upswing of the Many mature economies have July, oil is still trading close to ten- per 1,000 people, in India the figure oil pricing cycle, or when the trend failed to solve their own energy times 1998 levels. is 8 per 1,000. In China, car owner- reverses. Analysts have also been supply requirements at a time when There are a number of complex ship is reported to have increased attempting to price in the spin-off demand from emerging economies features in place that account for by one third in a single year in 2007, benefits for providers of energy is growing. New frontier discov- the dramatic rising trend over the reaching 20 per 1,000. The arrival Chris Palmer is head of equipment and services, a sector eries, such as offshore Brazil, could last decade. The thirteen mem- of low-cost cars, priced around global emerging markets which has outperformed in the potentially change the geopolitics of bers of Organisation of Petroleum US$2500, is also expected to boost at Gartmore Investment year to date. energy. Already, we have seen that Exporting Countries (OPEC), the trend – albeit at lower levels of Management However, the longer prices emerging markets dominate global which control more than 40% of energy consumption per vehicle. remain at elevated levels, the oil exports expect this to continue. the world’s oil, highlight the cur- While demand increases, there rency effect of the US dollar. Saudi are also a number of potentially Chart 1: London Brent crude oil index US$/BBL – price index Arabia, Nigeria and Iran have all market-distorting features in place. increased production in 2008, but Asian economies, such as China these nations also have a vested and India, have both had estab- 150 High over 12 months 145.65 04/07/08 interest in maintaining the value lished systems of subsidies which of their core asset for future gen- have kept prices approximately Low over 12 months 68.91 23/08/07 erations. Now the world economy 30% below market levels. In 2008, Avg of 12 months 101.60 is slowing. According to the Inter- both countries appear to have rec- national Energy Agency, non- ognised that these sytems are not 100 Performance OPEC output is forecast to increase viable. Both reduced subsidies in -1M -3M -12M by a small margin in 2009, amid 2008. A number of Latin econo- Actual value 138.45 121.99 70.41 some scepticism that this will be mies, including Mexico, also have achieved. The recent explosion on subsidies in place. 50 % change -17.02 -5.82 63.17 the Baku-Tblisi-Ceyhan (BTC) pipe- Within the market, the com- line carrying Azeri crude from the plexity lies in trying to forecast Background information Caspian Sea to Turkey highlights the interplay of economic, tech- Start date 21/11/1988 the possible vulnerability of sup- nological and environmental lim- 0 Currency US$ plies. This makes the market sensi- iting factors. The extraction of oil 98 99 00 01 02 03 04 05 06 07 08 Datatype PI tive to shifts in sentiment. from oil sands, shale, and in deep- On the demand side, the water offshore locations, is pos- LCRINDX momentum appears to be par- sible, for example, but constrained Source: Thomson datastream

three emerging markets, three sharpened skills ...one strategy Sharpen up your emerging market returns. Call Mark Roxburgh on +44 (0)20 7521 1360 or go to www.nomura-asset.co.uk corporate profile

Nomura Asset Management U.K. Limited Address: approach means that our investment Nomura House , process is designed to add value in all 1 St. Martin’s-le-Grand, London EC1A market conditions. 4NT, United Kingdom Products and services: Contact details: NAM’s goal is to provide “world class” Mark Roxburgh, head of marketing & products and client services to inves- standing and correctly forecasting client service tors, i.e., to provide products that cash flows is crucial to their valuation Email: mark.roxburgh meet the diverse and existing needs processes. Top down factors are con- @nomura-asset.co.uk of clients, achieve superior investment sidered to ensure that the macro-eco- Tel: 020-7521 1360 results, and give an exceptional level of nomic and political fundamentals are Fax: 020-7521 3330 client service. supportive. Although the overall port- Web: www.nomura.com/nam-europe We offer regional and country strate- folio has a growth bias, the managers gies covering Asia Pacific, Japan, India follow what could be described loosely Key personnel: and China. Additionally, we have estab- as a relative value approach, and the David da Silva, CFA, head of GEM lished a unique global emerging mar- combined style characteristics of the strategy kets equity strategy involving three strategy are purely a residual out- David da Silva is head of GEM strategy regional specialist managers: NAM in come. at Nomura Asset Management U.K. Singapore manages the Emerging Asia Limited. He has been with the firm region while two external specialist Research and development: since 2004. Prior to this he held product managers manage EMEA and Latin Our GEM strategy is the result of development and product specialist America regions. nearly five years of development on the roles in Morley Fund Management in part of Nomura. Both its development, London. David has an Honours B. Com Key features of investment and on-going credibility, relies on our Hons degree from the University of Cape process: belief that greater alpha will be gener- Town and in 1999 he attained the Char- The philosophy underlying our GEM ated by a regionally focussed specialist tered Financial Analyst designation. strategy has two basic tenets. The manager approach compared to that first is that stock selection is the available from one manager trying to Nomura’s Global Emerging Market best place to add value. The second cover all three regions. Strategy team: is that regional expertise is the This belief has been validated by Jolly Ng Kok Song, CFA, Nomura best approach to stock selection in annual studies (available on request) Asset Management Singapore emerging market investments. We conducted on our behalf by Oliver Gabor Sitanyi, CFA, head of research, believe that three regional specialists Wyman across the universe of over 200 Charlemagne Capital Limited are better placed to add alpha than competitor firms. The most recent one Chris Palmer, CFA, Gartmore Invest- one generalist manager. (for 2007) concluded the alpha uplift ment Limited Based on this belief, we comple- was 2% per annum. mented our emerging Asia exper- Background: tise with the skills of two regional Key facts: Wholly owned by the Nomura Group, specialists. Following competitive Total assets under management Nomura Asset Management (NAM) is search exercises we selected Charle- world-wide as at 30 June 2008 were one of the largest investment managers magne Capital as our EMEA (Europe, $250bn. GEM strategy has $479m as in the world. Middle East and Africa) specialist and at 30 June 2008. Our regional presence, extensive Gartmore Investment Management as experience and research capability in our Latin America specialist. Regional Distribution: Asian equities gives us global recogni- allocations are kept within a neutral The geographic distribution of institu- tion as a specialist manager. range around the MSCI Emerging tional assets worldwide is as follows: Market benchmark weights. Each of Equities: 53% Investment style and the specialists operates entirely inde- Fixed Income: 34% philosophy: pendently, we do not blend styles or Balanced: 6% NAM’s philosophy is founded on the strategies; resulting in a diversified, Other: 7% belief that capital markets are not regionally neutral strategy with global Source: NAM Tokyo as at 30 June 2008 fully efficient. Whilst there is scope for coverage. active fund managers to add value, to All three managers are predomi- This information was prepared by Nomura Asset Management U.K. Limited from sources it do so consistently requires considerable nantly stock pickers, focusing on reasonably believes to be accurate. This report resources, skill, and discipline. company fundamentals with com- may not be reproduced, distributed or published Our investment style is seen as a prehensive company visit policies. by any recipient without the written permission of “core” or “flexible”. We focus on identi- They place heavy emphasis on pri- Nomura Asset Management U.K. Limited. Nomura fying stocks which are trading at less mary research to complement third Asset Management U.K. Limited is authorised and than their fair value. Our relative value party research when available. Under- regulated by the Financial Services Authority.

28 Global Pensions Alternative investment and specialist equity strategies www.globalpensions.com sponsored article

l 785 benchmark companies; l 14,000 off-benchmark companies; The poacher’s guide l 25 countries, 26 currencies, 60+ languages. The geographical spread of the countries alone implies considerable time to game-keeping in spent on aircraft, not to mention regular exposure to jetlag – provided that you need to actually go and see the companies, of course. Quantitative managers, emerging markets or those based in a major centre such as London or New York, expecting their investee companies to come to them, do not suffer from this issue. However, we believe that a fundamental manager will derive benefit from meeting companies on the ground, and so we look for firms that make regular trips to the regions they invest in (and have the language skills and relevant cultural awareness), or base their analysts close to the companies they research. Research must be focused and organised to suit the resources of the firm and its philosophy. Quantitative managers have their own challenges to face; high on the list will be the difficulty of sourcing accurate data as inputs and ensuring that models, often imported from developed markets and “adapted”, add genuine value. There are undoubtedly some excellent quantitative emerging markets managers, but they do not suit our requirements, and hence we do not consider them. As The performance of emerging market choosing external investment man- a result, we make no comment on their investment managers over recent years agers in Emerging EMEA and Latin selection in this article. has been (on average) so dismal* that America to complement our own exper- an observer might conclude these mar- tise in Emerging Asia. We also select Local presence, language ability kets are amongst the most efficient in back-up managers and monitor the uni- We believe that local knowledge of the the world. This is patent nonsense. verse of suitable candidates. That puts markets in which managers invest is Liquidity-driven bubbles in China, far- us in the business of manager selection preferable. Therefore we seek (ideally) beyond-consensus commodity price as well as asset management. So we are managers whose analysts or portfolio appreciation, unexpected political both “poacher” and “game-keeper”. We managers have lived, or do live, in the instability, fundamentals ignored – we hope that by reading this article, you *An analysis of a countries of their speciality and speak universe of 182 global have heard the excuses. What should will appreciate how we choose invest- emerging market their languages. the investor in emerging markets be ment managers, and this knowledge funds constructed by That local knowledge will aid deci- looking for from his manager – how to will be useful in making your own Oliver Wyman found sion-making is intuitive, particularly pick the winners in emerging markets? selections. We also hope it will stimu- more than 75% of given the strong influence of local poli- Somewhat unusually, Nomura Asset late you to be interested in our fund. funds underperformed tics on the emerging world, and given Management (“Nomura”), one of the We suspect that many of the ideas the MSCI Emerging the largest sector in the MSCI Emerging “poachers” in these woods, can offer an raised in this article would be shared Market Index (net of fees) over two years to Markets Index is Financials, where interesting perspective. by the true “game-keepers” – the invest- 31 March 2008. profits are heavily influenced by local ment consultants, many of whom have economic conditions. However, there How should we know? enviable manager research resources. is little statistical evidence to back up This article sets out some key points For those investors with insufficient the theory. In 2007, a study by Melvyn you should be looking for when in-house resource to undertake the Teo (The Geography of Hedge Funds, appointing an emerging markets man- research described in this article, we Melvyn Teo, University of Singapore ) ager. However, before we begin, we recommend that the advice of an invest- showed that hedge funds with a phys- ought to establish a little credibility. ment consultant is sought in the man- ical presence in their investment region Nomura is an asset manager after all, ager selection process. outperform others. Hedge funds and so why should anyone trust an asset long-only active equity funds are very manager on the subject of how to pick Take pity on the managers different animals of course, but they asset managers? It can be difficult to feel sorry for any share the goal of adding value through Nomura’s regional emerging market investment manager, but consider the informational advantage, so we believe strategy is somewhat unique. We have challenge faced by an emerging mar- this research supports our preference. built a global emerging product by kets specialist: Similarly, Oliver Wyman’s 2008

26 Global Pensions Alternative investment and specialist equity strategies www.globalpensions.com sponsored article

study (Emerging Markets Product and ensuring they could continue to Analysis, Year end 2007 update) of liquidate 75% of the portfolio over a regional emerging market equity man- ten-day period using only a fraction of agers demonstrated that regional average daily trading volume. However, funds, when combined to give global that figure is (intentionally) conserva- coverage, outperform global emerging tive and, for some managers, a higher market managers. Regional managers capacity figure may be appropriate. can be closer to the markets in which Moreover, it should be remembered separate from portfolio management), they invest, and their alpha advantage that liquidity is not static. At end June, broker use and assessment, order is proven. Chart 2 illustrates the results the free-float of the MSCI Emerging processing systems and trade cost of the study. Market Index was US$3.3trn, a figure monitoring can reveal potential sources that has doubled in three years. Larger, of problems. This important area Digging deep more liquid markets should yield higher should not be ignored in the selection of Large cap stocks in the emerging mar- capacity numbers. managers. kets are well covered by sell-side analysts. Whilst this coverage can have Portfolio construction and risk Conclusion an unsubtle (sale focussed) agenda control This article cannot present an exhaus- and can be short termist in nature, Beyond looking for a clear link between tive list of what we look for in a man- the sheer number of investors delving conviction and risk allocation, it is ager (and no manager is “perfect”), into company finances, absorbing important to identify any systematic but it gives a guide to what we believe newsflow and forecasting “fair value” biases in portfolio construction (partic- Fraser Hedgley, CFA, to be vital. In choosing a fundamental is a product specialist implies a degree of efficiency. At the ularly tilts that are not in keeping with for Nomura’s Global emerging markets manager, we recom- mid to small cap end, the number of the manager’s philosophy or research Emerging Market mend seeking one close to its market, analysts covering companies drops process). Many managers in this space Strategy. with product focus and the means to away sharply. To give an indication of rely on the output of BARRATM and retain its key staff. Look for purposeful, this, Gazprom (the Russian oil giant, “experience” to keep their risk under organised research feeding into a clear and one of the largest index stocks) was control, but we seek managers who are portfolio construction process, with a examined in 46 separate reports posted aware of the risks relevant to their fore- dealing team and back office that will to Bloomberg in July alone. By contrast, casts (e.g. interest rates, oil price, etc) not “give back” the hard-earned alpha there have been just 15 reports relevant both at stock and portfolio level and of the investment team. Keep an eye on to Arabtec (one of the more recent and stress test to confirm their thinking. capacity – walk away if you believe a smaller cap stocks added to the Nomura We are content with managers using manager to be hampered. portfolio) added so far in 2008. consensus forecasts for such vari- Nomura, by researching regional ables where they feel they cannot add managers, typically comes into contact value, but they should understand the Chart 1: Above average regional (Asia, EMEA, Latin America) with teams who have the resource and portfolio consequences of “consensus” managers in combination have outperformed global emerging the willing to research the small cap being wrong. market managers over the five years to end 2007by 2%p.a. and off-benchmark areas of the market for pricing anomalies. Those investors Organisation Returns vs. tracking errors over five years seeking managers who operate on a We look for product focus – firms not 45% 44% global basis should seek similar reas- trying to be all things to all people, Type Returns T.erroe 43% Above avg. global 38% 5.6% surance. and focusing on their competitive 42% Above avg. global 38% 5.6% advantages. Alignment of interests 41% Capacity – how much is too with clients is important, and the firm 40% much? must have adequate retention poli- 39% 38%

One factor that prevents many man- cies in place, particularly in the case 37% Alpha advantage and risk reduction of regional funds agers from investigating small cap of smaller teams, where a number of 36% companies is capacity. Large funds will individuals may be key. The support 35% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% fail to research small companies simply of parent organisations/owners is also Annualised tracking error because it is impossible for them to an element to look for, as is a degree of gain a meaningful position. Growing autonomy. Source: Bloomberg, MSCI, Oliver Wyman analysis. Note: above average funds are defined as comprised of managers with above average returns over defined time period asset sizes lead to other symptoms which erode alpha: stocks ignored due The details Chart 2: The charts indicate (by size of bubble) the size of to the inability to trade without moving Through trading costs, errors and inef- assets under management of the greatest asset-gathering markets and stocks held on to for too ficiencies, alpha can be given away. It emerging market managers at end 2005, and the contrast in their long once they pass price targets. is an expensive luxury to have compli- performance over the three years ending 2005 and 2007 The question then becomes, ‘How ance, risk management experts and Three years ending 2005 Three years ending 2007 10 much is too much?’, a question that pro- portfolio administration teams review 12 vokes much mumbling and downward the operations of the managers one 6 8 glances throughout the asset manage- selects – it is a review that few inves- 2 ment world. The phrase, “We are reluc- tors will undertake. From Nomura’s 4 tant to give a hard figure for capacity,” point of view, it is an unacceptable (2) – grows increasingly hackneyed with reputational risk not to undertake such (6) (4) each manager interviewed. Here’s our a review (and we periodically re-check (10) (8) hard figure: US$5bn. That figure was our findings). However, in place of such 2 3 4 5 6 7 2 3 4 5 6 7 derived from looking at the portfolios a detailed check, careful questioning Tracking error Tracking error of each of our underlying managers about dealing functions (preferably Source: Provided by Intersec Research www.globalpensions.com Global Pensions Alternative investment and specialist equity strategies SUPPLEMENT 27 44 June 2008 Sponsored article www.globalpensions.com

Dedicated emerging market average performing regional managers, managers outperform with the universe of above average global Studies conducted by US-based Intersec managers. The composites of regional ResearchTM reveal that the focus of dedi- managers not only outperform the global cated emerging markets managers has led managers by 2%p.a. on average, they do them to outperform the emerging market so with lower tracking errors to the MSCI allocations of Europe, Africa and Far East Emerging Market Index. (“EAFE”) and International managers. In our view, the results of this analysis Chart 1 illustrates this result, comparing also cast doubt on the extent to which the information ratios of broad mandate – global managers add value through active EAFE and International (labelled “ACWI”) regional asset allocation. The compos- managers – with those of global emerging ites of regional managers were neutrally market (“GEM”) specialists. Over all weighted to the regions (and thus had no periods shown, the median GEM specialist access to this potential alpha source). Nev- manager has generated positive informa- ertheless, (on average) they outperformed tion ratios, higher than those of the median global emerging market managers. EAFE and International managers. Who’s got the alpha in The evidence suggests that the appoint- Difficulties of appointing ment of a dedicated emerging markets regional specialists specialist would have been beneficial There are downsides to appointing spe- for investors over recent years. Not only cialist managers. The investor may well emerging markets? would such an appointment have allowed have to allow for higher overall fees in a investors to fully participate in the specialist structure and greater govern- This article makes the case for appointing balanced mandates have become vastly emerging market growth story that has ance and administration costs. If the allo- dedicated managers of emerging market outnumbered by specialist structures. driven returns so strongly over recent cation to emerging markets is small, the equities. Further, it explores the merits The number of investment houses with years, it would also have ensured that use of pooled funds may be unavoidable if and difficulties of obtaining this expo- genuine expertise in managing just bonds investors achieved a superior alpha con- specialists are used, since the assets avail- sure through regional specialists within and equities (let alone the increasingly tribution from their active managers. able are split between a greater number of the EMEA, Asia and Latin American overwhelming array of alternative invest- Whilst a dedicated emerging markets managers. Also, the difficulty of finding emerging markets. The results of inde- ments) remains low, and tactical asset allo- manager is therefore a worthy addition to skilled managers and monitoring their pendent research and research conducted cation is a specialist world dominated by a a broader equity manager line-up, is there progress can be considerable. NAM can by Oliver Wyman on behalf of Nomura few highly-resourced quant houses. merit in taking the idea of specialist man- certainly testify to this point; since NAM Asset Management U.K. Ltd. (“NAM”) agement further? first built a combination of regional spe- suggest that a considerable increase in Equity mandates lack cialists into a single product in 2006, it has alpha is available to investors prepared to specialisation Can regional specialisation been a continuous challenge to identify a appoint regional specialists. If we drill down one strategic level into improve returns in emerging sufficiently broad set of skilled candidate equities and particularly the emerging markets? managers in each region that remain open First steps into specialist markets, the idea of abandoning generalist If specialism at the global emerging to new business. management managers in favour of specialists has not market level can increase returns, it seems For the very largest institutions, with Roughly 20 years ago, the idea of “bal- taken hold. Worldwide, institutions award natural to pursue the concept and inves- extensive in-house resources, these diffi- anced” mandates was set aside in favour Global or “International” equity mandates tigate specialism one level further down; culties may be surmountable, and NAM’s of specialist managers of equities, bonds, far more frequently than any other appoint- to check whether regional specialisation experience suggests the effort involved property, etc, working within a strategic ment. These mandates often allow man- within the emerging markets improves can be amply rewarded. However, smaller allocation governed by fixed weights and/ agers a small allocation to the emerging performance. The case for doing so institutions may have their options limited or market capitalisations. The rationale markets, as either an off-benchmark allo- appears still stronger when we consider to a small number of providers or fund-of- was simple: few investment managers cation from a developed market mandate the obstacles to successful, fundamental funds (many with an additional level of could (in good conscience) claim to be (which has provided a useful boost to per- emerging market equity research: fees) if they are to benefit. skilled in managing all asset classes and formance in recent years), or as part of an fewer still could claim to be skilled tac- “All Countries” benchmark. This seems • Benchmark of 900+ stocks (MSCI EM) Conclusion tical asset allocators. contrary to the idea of specialisation that is • Circa 14,000 stocks off-benchmark As demonstrated by the research, spe- That rationale applies equally today and so established at the equity/bond level. • 27 countries, 27 currencies, 70+ lan- cialist emerging market managers have, guages on average, outperformed the emerging Chart 1: Information Ratios of Europe, Africa and Far East (“EAFE”), International (“ACWI ex US”) • Geographical spread of markets market allocations of more broadly-man- and Global Emerging Market (“GEM”) managers over periods ending 31 December 2007 • Varied accounting and reporting prac- dated investment managers. Similarly, 1 Year 3 Year 5 Year tices research shows that combining specialists 5 • Country-specific factor influence on within the EMEA, Asia and Latin Amer- 4 equity performance ican regions has, on average, improved 3 risk/return outcomes over those of more 2 NAM commissioned Oliver Wyman traditional global emerging market man- 1 in 2006 to investigate the potential of agers. This reinforces the widely accepted 0 regional specialist manager combina- idea that specialist managers with more -1 tions. They found that an average of the focus and resources to devote to a partic-

within broad & specialists -2 regional specialists in the EMEA, Asia ular area of investing will outperform gen-

Emerging markets information ratio -3 and Latin America regions, combined (at eralists. For large investors with sufficient -4 regional market weights) to form a syn- resources, or smaller investors with access -5 thetic “global” strategy, outperformed the to cost-effective fund-of-funds or similar EAFE ACWI GEM EAFE ACWI GEM EAFE ACWI GEM ex-US ex-US ex-US average global emerging market manager products, seeking regional specialist Source: Intersec Research over one, three and five years ending 31 emerging market managers should be December 2005. This study was conducted strongly considered based on our evidence. Chart 2: Annualised returns plotted against tracking error for above-average global emerging on a net of fees basis. Oliver Wyman has market funds (blue dots) and for composites of above-average regional managers (red dots) since repeated the study on two occasions, Fraser Hedgley, CFA, 45% using data ending December 2006 and GEM Product Specialist 44% December 2007; the results are consistent 43% with the original findings. On each occa- The contents of this article are not intended in any 42% sion, combinations of regional specialists way to indicate or guarantee future investment 41% Type Returns T Error 40% Above avg global 38% 56% were found to have outperformed global results as the value of investments may go down Above avg global 40% 49% 39% managers. as well as up. In particular, past performance 38% Increased return is beneficial for inves- may not be relied on as a guide to future 37% tors, but it is reasonable to expect combi- performance. Nomura Asset Management U.K. average composite funds 36% nations of regional managers to yield some Ltd. is authorised and regulated by the Financial Above average global funds vs. above returns vs. tracking error over five years 35% diversification of manager style also, so Services Authority. 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% Annualised tracking error we might expect to see a decrease in risk. Global Top composite From the latest Oliver Wyman study, Chart Source: Bloomberg, MSCI, Nomura, Oliver Wyman analysis. Note: Above average funds are defined as funds comprised of managers with 2 compares a universe of “composites”, above average returns over the defined time period. formed by combining (at random) above 31 NomuraADV MayJun08:HSBC 2/5/08 17:00 Page 31

EXPERT VIEW Investing in ‘emerging’ Europe Many economies in Central and Eastern Europe offer attractive investment opportunities to trustees, says David da Silva, CFA of Nomura Asset Management UK Limited

What are the market opportunities in emerging the 12 months to 25th April 2008, EM Europe proximity is important, especially in terms of Europe? has lagged the performances of Asia and Latin trade, the influence of the EU is deeper than this The investment opportunities in the region stem America by 11% and 28% respectively, and is having an impact further afield. In from the favourable political and economic delivering a modest 10% return in US dollars. comparison to such regions as Asia and Latin climate which has been ushered in post the All data references taken from MSCI and IBES America, it would perhaps be fair to say that this communist era. The market friendly conditions Aggregates, 25th April 2008. European tie does equate to less risk as policy have created opportunities for individuals and actions are constrained by such ambitions. firms alike: low labour costs, coupled with high What are the key macro dynamics in the However, it is worth pointing out that as with any education standards, and strong productivity region? market, risks remain and that unexpected political have prompted many multinational companies As stated in the previous answer, the favourable and or economic developments might jeopardise to set up bases in the region. Our GEM strategy macroeconomic backdrop is underpinning its future returns. philosophy at Nomura Asset Management is to competitiveness, and this in turn is attracting work with regional specialists who are best foreign direct investment. As confidence grows, How well established are these stock markets? placed to extract the alpha from these markets. we are seeing rising consumer demand. The region’s stock markets, in their present form, For emerging Europe we work with Charlemagne However, the region cannot be separated from are relatively new arrivals, having been set up in Capital, an emerging market specialist company current global themes: financial distress, rising the early 1990s following the collapse of with extensive experience in the region. They commodity and food prices, inflationary Communism. However, despite this short history add that an important factor supporting the concerns and the monetary policy response. the Russian stock market has become a dominant macro environment has been accession, or even Charlemagne make the point that the impact of player in the region, thanks to the size of its potential accession, to the EU which has the sub-prime crisis and credit crunch is economy and the strong performance of its energy prompted a responsible fiscal, regulatory and nowhere near as pronounced as what we have and materials sector, with a market capitalization legal framework to the clear benefit of the seen in developed economies. This is a in excess of USD 1,000 billion. This places it in corporate sector. Russia is a special case, consequence of the fact that these emerging the same league as the largest stock markets although not subject to the influence of the EU economies are not as closely linked into the anywhere in the world. National stockmarkets in in the same way as the countries of central international credit markets, and are funded in some other countries continue to struggle Europe, it is nevertheless pursuing an equally essence by their own domestic depositor bases. however and this may, in time, lead to some ambitious programme of reform which is seeing Regardless, we believe that it is perhaps better consolidation in the industry. As Charlemagne its economy move away from a dependency on to view these markets in the context of their make clear, from an investors point of view, it the energy and materials sectors to more broadly relationship with Developed Europe. The latter matters little whether emerging European based activity with consumer demand at its has shown encouraging resilience to the current companies are traded locally or abroad. Indeed, in core. Furthermore it is worth noting that as global slow down and this has provided some some respects it may be more secure and less economies close to the EU mature and develop, support to the satellite emerging economies risky to use western exchanges, particularly when others appear on the radar screen, offering which are dependent on these export markets. investing in some of the new Frontier markets. ■ perhaps the same opportunities to investors as It is also worthwhile considering the region central European economies offered ten years from a longer term perspective, as Charlemagne Thanks to John Dawe at Charlemagne Capital for ago and more. These markets include those highlight, emerging Europe is still throwing off his contributions labelled as “Frontier”, such as Kazakhstan, and its communist yoke and putting its own prospects for these countries have been economies in order. To a large extent this David da Silva, CFA, is employed by Nomura Asset recognized by the likes of the index provider process is helped by the lure of the EU and the Management U.K. Limited (NAM UK), a firm authorised and MSCI as well as by the number of funds now Euro, as touched upon earlier. The results regulated by the Financial Services Authority. Information beginning to invest in this area. however are already apparent in improving fiscal and data referenced in the above answers has been taken Consequently, from a fundamental balances and current account surpluses (though from sources NAM U.K reasonably believes to be accurate. perspective emerging Europe seems attractive, not in every country), which some would say The contents are not intended in any way to indicate or but what is important from an investor’s were necessary prerequisites for successful guarantee future investment results as the value of investments may go down as well as up. Values may also be perspective is whether the valuations reflect this investment. The increasing importance of the affected by exchange rate movements and investors may not yet. We believe that valuations are attractive consumer sector is also providing some get back the full amount originally invested. Before though specialist regional skills are needed to insurance against external woes. purchasing any investment fund or product, you should read uncover the best opportunities. On a relative the related prospectus and/or documentation in order to basis, forward price to earnings ratios for MSCI Does the region offer less risk by virtue of its form your own assessment and judgment and, to make an EM Europe are currently approximately 30% proximity to EU? investment decision below the average ratios in MSCI EM Asia and EU accession and integration have resulted in EM Latin America. Furthermore, the current what many perceive as a less risky environment By David da Silva, CFA level is in line with the five year average in which to invest, a view supported by our whereas for the other regions they are above regional specialist Charlemagne. They add that of Nomura Asset their respective averages. These favourable the proximity of the EU has been central to the Management UK Limited valuations however should be weighed against economic renaissance of the region and will the fact that earnings growth rates are at roughly most likely continue to provide a positive input a 30% discount to the other regions, and over for many years to come. Though physical

ENGAGED INVESTOR MAY/JUNE 2008 31 22 | Professional Pensions | 15 May 2008 www.professionalpensions.com conjecture

Panellists exchange views on emerging markets, discussing alternative methods of selection, where the current alpha generators lie and predictions for how the asset class will develop over the next five years no QuiCK fixes

The second Professional through fairly unscathed, albeit people skill set to actually Pensions Conjecture debate affected by, but not directly implement a standalone looked at the case for scheme impacted by, the credit crisis. mandate and there isn’t any investment in emerging markets. As far as the broad economic particular solution that applies Joining Professional case is concerned, it really across the board. Pensions editor Len Roberts comes down to one key thing: I think the large funds were Nomura head of that the current share of world tend to go for a dedicated marketing and client service market cap emerging markets asset exposure and the more Mark Roxburgh, Aerion Fund enjoy – perhaps 12pc of the medium-sized ones perhaps Management investment total – doesn’t really reflect might see it as part of a global director John Arthur and the very fundamental gross equity portfolio, and then there Mercer principal Debbie Clarke. domestic product contribution is a whole raft of people in that they make. between. It is really down to the particular circumstances of the LR: What are your views about JA: Longer term, I am totally fund concerned. emerging markets generally, in tune with Mark here. I the effect of the credit crunch think one has to accept that DC: The issue for trustees is Len roberts Mark roxburgh and why trustees should be the growth rates will be faster very much as Mark said – it is considering an allocation to the in emerging markets, and the governance of how they get asset class? therefore one should see faster that exposure. Clearly, pension growing profits, share prices funds have quite a lot to think MR: Over the last five years, and a better return. about at the moment and the pensions schemes that have question of whether or not it had exposure have done DC: Fundamentally, I think should be global or emerging exceptionally well relative emerging markets are less market is perhaps some way to perhaps more developed efficient than the developed down their thinking. markets. Although there will markets and ultimately that be volatility going forward, should be a good long-term JA: We see it as part of our we still think there is a very opportunity for pension funds equity allocation within the fundamental economic case built on a long-term basis. fund, mainly because of the on either increased exposure to material correlation between emerging markets. LR: Should emerging markets emerging markets returns and As far as the credit crunch is be seen as an asset class in its developed market returns. concerned, I think we need to try own right, or part of a global However, our benchmark debbie Clarke john arthur to keep it in proportion. This is equity portfolio? includes a weighting in primarily an issue for developed emerging markets – making it markets rather than emerging MR: One of the factors will be that bit harder to beat. MR: I think one of the issues In reality, they might look at markets and, to that extent, whether the fund has enough trustees have to identify is where the performance and think emerging markets have come of a governance budget or LR: What are the questions they are going to take the assets they would like to capture trustees should be asking from in order to put this into that. Most of them are looking when they are considering an emerging markets. at it from that longer-term PROFESSIONAL PENSIONS EVENTS CALENDAR allocation to emerging markets? perspective and that is what LR: Is there a temptation they have to do. JUNE 19 DC: Trustees should be asking for trustees to see emerging PIMCO what volatility the management markets as a quick fix? MR: I agree, I think a core are expecting in terms of the allocation, as John and Debbie Leeds/London/Birmingham asset class and how they are JA: I think there might be a have mentioned, is the way JULY 9 actually managing the funds in thought that it can be a quick forward and that is certainly BULK BUYOUT FORUM terms of the risks they are taking. fix and if people feel that they what we see funds actually doing. But the important thing is have the ability to make that London for trustees to ask themselves decision and make that call, JA: One point I would like to SEPTEMBER 11 if they are comfortable with the then by all means. add to that: the other issue with PENSION SCHEME OF THE YEAR AWARDS long-term perspective they have We do not feel we have the emerging markets is the cost to take. expertise to make that sort – the cost of dealing, the cost of Park Lane Hilton, London of call, particularly where access and management fees. SEPTEMBER 11 JA: I agree with that entirely. the trustees set us a strategic This suggests that you should MFI FORUM It is fundamentally about the benchmark. take a slightly longer-term view risk appetite of the fund and So we will move slightly because you are paying more Park Lane Hilton, London the trustees and, in my mind, overweight, slightly under- NOVEMBER 19 it has to be done on a long term weight emerging markets but MR: And maybe just one PROFESSIONAL PENSIONS SHOW basis. Without that, then I in terms of long term, it has other point. There are differing ExCeL, London think you are running a risk been a decision set up by the standards of corporate of getting disappointing trustees in consultation with governance in emerging markets NOVEMBER 28 returns in the short term and their advisers. and this is something trustees SAIM AWARDS finding you have not got the would need to be comfortable risk budget or the capital DC: I don’t think many trustees with and to understand before The Renaissance, Chancery Court, London backing to accept that. are looking at it as a quick fix. making an allocation.

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DC: I would agree with Mark the time to take that sort of risk come through and incorporating traditional equity classes in emerging markets have been about the whole corporate and reap the higher returns. those into the global emerging terms of fees. slightly disappointing. governance perspective on this. markets mandates. However, I think the real I think emerging markets A key part of what we look for LR: Where are most of the issue is to ask about the alpha will provide better returns but in emerging market managers alpha generators in the MR: I certainly think that a a manager can produce. If you would be more comfortable is how they deal with corporate emerging markets mandates? manager who is focused on the can find a successful manager saying that if I was governance in emerging region should be able to exploit or managers who are going to commenting over a 10 or 20- markets because it is very MR: Our general principle those frontier markets. I think produce you north of 3pc per year time period. different from what you have in would be that we believe that they are interesting markets annum, then higher fees are not western markets. the greatest inefficiencies are and, as long as the manager that significant in the context. DC: If you look at the last probably at the stock level and has got a skill set in that area, three to five-year numbers, LR: I understand there are that creates opportunities for they should be given the remit LR: How will the asset class investors have had 40pc plus concerns about capacity though, managers who have a research because it will be a source of develop over the next five years? returns from emerging markets and some managers have now or resource base that enables additional return but not add a and on a five-year view, while actually closed to new business. them to exploit that. significant amount of risk to the MR: We think pension funds in we still expect returns to be overall portfolio. the UK will allocate more money high, I think we have perhaps Is this actually inhibiting the JA: Yes, our experience has to the asset class. had the best of emerging growth of the asset class? been that it is the inefficiencies JA: It is a balance, it is a useful We will clearly see some markets in that period. Despite at the company level. You have way of looking at things; it volatility as a result of ongoing this, on a 10 to 20- year view, JA: I think there is an issue here got less perfect information, should add more value but on effects of the credit crisis. But we still see emerging markets and of course it is quite often you have got less people doing the other side, anything more we still think the fundamentals as offering excess returns the better managers that run up the research so right down complex takes more time and look quite attractive. So perhaps relative to other markets. against that problem. at the company level, that effort to monitor. lower returns but we still think This is particularly an issue is where we see the major there will be good returns over next conjecture debate for smaller funds where having inefficiencies. LR: Are fees a constraint on the medium term versus the more For more information on the next the clout and the leverage to the growth of the sector? Is it developed markets of the world. Conjecture debate please visit get access to those managers is DC: I would agree with both a key issue? www.professionalpensions.com quite difficult. Mark and John in terms of if one JA: I would assume the higher looks back again over the years, MR: We are not in hedge beta of emerging markets and MR: I saw some statistics then increasingly it has been fund territory here but I think the ability to add alpha better the other day that suggested stock selection that has driven you are probably looking at in less perfect markets should something like nine out of the performance. And that has emerging markets as being lead to higher returns but we top 15 business winners in the been the area where you get the certainly one of the higher have had five-year periods when US market in this asset class greatest inefficiency. were closed to new business. So it is very much a capacity- LR: Mark, I think you have constrained market and it a slightly different way of Document Watch is crucial to make sure that selection, don’t you? Could you The following documents are among those that we have received in the last month. If you wish to have a document listed in our you know how your selected give us your views on that? manager is going to manage table next month, or would like more information about Perspective, please contact Pendragon: Paulton House, 8 Shepherdess Walk, that capacity issue. MR: We combine with London N1 7LB, Tel: (020) 7608 9000, Fax: (020) 7608 9009, Email: [email protected] some external managers to Legislation and Draft Legislation DC: Yes, I think capacity is an provide a global emerging issue in this asset class and markets product. Pensions Bill (HL Bill 50) and Explanatory Notes The Stationery Office what we look for in terms of We asked an independent The Occupational Pension Schemes (Transfer Values) The Stationery Office that is managers who have some consultant to look at where the (Amendment) Regulations 2008, SI 2008/1050 sort of framework for thinking alpha was being generated and The Occupational Pension Schemes (Employer Debt – Apportionment Arrangements) The Stationery Office about capacity, monitor that whether a regional structure (Amendment) Regulations 2008, SI 2008/1068 The Stationery Office framework well and then close would actually offer investors The Local Government Pension Scheme (Amendment) Regulations 2008, SI 2008/1083 The Stationery Office when they recognise that they more alpha on the basis that The Firefighters’ PensionS cheme (Scotland) Order 2007 Amendment Order 2008, SSI 2008/160 the Stationery Office are reaching capacity and they managers would be close to The Firefighters’ PensionS cheme Amendment (Scotland) Order 2008, SSI 2008/161 The Stationery Office actually can’t continue to add the region and they would The draft Financial Assistance Scheme (Miscellaneous Provisions) Regulations 2008 The Stationery Office the alpha. have better information; better information would mean better Regulatory and Industry Materials LR: Are emerging markets decisions and better decisions Draft Finance Bill Guidance: HM Revenue and Customs suitable for defined should produce more alpha. • Overseas pension schemes – amendment of pension input amount contribution plans? They suggested this sort • Benefit CrystallisationE vent 3 test of structure could increase • Inheriting tax-relieved pension savings MR: It obviously depends on returns by between 60 and The powers of the Pensions Regulator: Amendments to the anti-avoidance measures in department for Work and Pensions the investment horizon of the 200 basis points per annum the Pensions Act 2004 individual in the plan. Given if you could get some good Government responses to various consultations including: Non-European Schemes department for Work and Pensions what we said about emerging quality regional managers Exemption; Internal Dispute Resolution Procedures; Transfer Values; Cross-border Activities; Financial Assistance Scheme markets being perhaps a in place. Pensions Regulator Corporate plan 2008-2011 The Pensions Regulator medium to longer-term asset Multi-employer withdrawal arrangements The Pensions Regulator allocation call, then I guess it JA: If it can be provided in an Section 89 report – G.E.C. 1972 Plan (telent) The Pensions Regulator is probably more appropriate efficient manner from a fee Trustee Good Practice Guide: Guidelines for trustees managing pension schemes through the Pension Protection Fund for people at the earlier part of perspective, then I believe that Pension Protection Fund assessment period (consultation) their pension planning, rather having an Asian manager, a Consultation on the requirement under Section 171 of the Pensions Act 2004 to equalise Pension Protection Fund than perhaps in the latter Europe, Africa, Middle East compensation to allow for differences in the GMP formula stages where the volatility that manager and a Latin America Management Plan 2008/09 - 2010/11 Incorporating Business Plan 2008/09 Pension Protection Fund we have discussed may be a manager grouped together in a BriefingN ote 45 - Choosing a charging structure for personal accounts Pensions Policy Institute bit inappropriate. fund should be an interesting way to look at the asset class. Conceptual Framework for Technical Actuarial Standards and Scope & Authority of Board for Actuarial Standards Technical Standards Exposure Drafts DC: My view would be that it is exactly the sort of asset class DC: If you can find people and Structure of new BAS standards (and implications for adopted GNs): Consultation Paper Board for Actuarial Standards that a DC investor who is looking can put the managers together Exposure Draft: Reporting Actuarial Information Board for Actuarial Standards to invest over the next 30 to 40 without additional fees then that Committee of Public Accounts Fifteenth Report of Session 2007–08: The Stationery Office years should be investing in. could be interesting. The Pensions Regulator: Progress in establishing its new regulatory arrangements (HC 122) I think the other thing that BriefingN ote 46 - How much will pensions and long-term care cost in the future? The Pensions Policy Institute I think again it comes down perhaps global emerging JA: Miscellaneous to longevity and what your markets managers bring to the timeframe is. It is all about piece is those who are good at Survey on fully funded, technical provisions and security mechanisms in the European occupational pension sector CEIOPS taking risk in the belief of perhaps identifying some of Recommendation On Good Practices For Financial Education Relating To Private Pensions: OECD higher returns where you have the frontier countries as those Recommendation Of The Council

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34 EMERGING MARKETS

Emerging markets provide the opportunity to add value

IF INVESTORS STRUCTURE A PORTFOLIO TO TAKE ADVANTAGE OF THE PROSPECTS OFFERED BY EMERGING MARKETS, THEY COULD ACHIEVE OUTPERFORMANCE, SAYS PETER JENKINS

merging market equities markets look ripe for profit-taking. E rewarded investors with International investors will take great performance over profits wherever they have them the last year and have produced and for those investors that have excellent returns over a longer had a decent exposure to this Peter Jenkins period. The MSCI Emerging asset class for any length of time, Markets Index has produced long- there are temptingly large gains to term outperformance since its be realised. It is for this reason inception in 1988. Those of you that in times of crisis markets wary of the volatility of emerging tend to move together; ie markets markets and aware that recent become more correlated. However, falls have been worse than those looking beyond the immediate suffered in developed markets, concerns, the prospects for might view these losses in the con- emerging markets remain very text of long-term gains achieved so bright. far.For over 20 years the MSCI Over the longer term, equity emerging markets returns have markets will follow the growth of been more than double those economies and corporate earn- G Emerging achieved in, for example, the S&P ings, and both are likely to be sig- markets will 500, and four times those achieved nificantly greater in the case of define general by the MSCI World Index. emerging markets than in devel- market direction Looking forward, the short- oped markets. From our studies in the short term term outlook is somewhat over the next few years we expect G Underexposure cloudier, reflecting a more uncer- emerging market GDP growth to to the asset tain global economic picture. As average 6%-7% annually, a figure class bodes has happened in 2008 to date, two to four times greater than the well for future developments in developed equivalent for G7 economies, and performance economies and markets will likely we expect annual corporate earn- G The DWP is be the major factor determining ings growth to exceed those num- taking a closer market direction for the moment, bers. Against this backdrop of look at scheme particularly if the global market robust earnings growth, emerging governance downturn continues as emerging market valuations remain attrac- EMERGING MARKETS 35

tive; the forecast price earnings perform what we already expect to ratio (PER) on 2008 earnings is less be an outperforming asset class. than 12 times, only slightly above The whole structure of emerging the five-year average, and a sub- markets and the way they operate stantial discount to developed gives fundamental and disciplined markets. investors a chance to outperform Despite the fact the growth pro- the indices without taking undue file and valuations are attractive, risks; namely adding alpha. Alpha and emerging markets have been is a measure of the difference receiving strong fund inflows in between a fund’s actual returns and its expected performance, “OVER AND ABOVE THE given its level of risk against mar- ATTRACTIONS OF TOP ket indices as measured by beta. In LINE GROWTH, AN ADDI- this sense it is a good measure of TIONAL ATTRACTION OF the value added by a manager over EMERGING MARKETS and above movements of the index. FIVE TO INVESTORS ARE THE There are three main reasons OPPORTUNITIES THEY why this is achievable in the con- AFFORD TO SIGNIFI- text of emerging market equities. CANTLY OUTPERFORM Firstly, the global emerging mar- THE INDICES” ket universe allows for a much wider degree of diversification recent years, we believe that these over and above that which can be will continue as emerging markets achieved through a spread of are still significantly under-repre- investments across developed mar- sented in investors’ portfolios; in kets. Emerging markets embrace a short G7 investors and savers wide range of countries in differ- remain structurally underweight ent geographical locations with this asset class. This state of affairs different economic structures and is all the more surprising given at very different levels of develop- that global equity indices gener- ment. They range from giant ally carry neutral emerging mar- resource rich economies such as ket weights at well below 10%. Russia and Brazil, through to man- This current level of under- ufacturing based economies such exposure augurs well for market as Korea; from countries at a very performance in the future. basic level of development to Over and above the attractions countries as developed and of top line growth, an additional wealthy as Taiwan; from relatively attraction of emerging markets to unrestricted economies such as investors are the opportunities Chile, to those with much state they afford to significantly outper- intervention and restricted capital form the indices; in short, to out- accounts, such as China; and from 36 EMERGING MARKETS

states which have freely floating outperformance from the Middle exchange rates to those that East region where, benefiting actively manage or even peg their from high oil prices, markets such currencies. as Jordan, Bahrain, Oman, Qatar The case for diversifying portfo- and Kuwait rose strongly, the lat- lios through emerging market ter up by over 10%. exposure is captured in the rela- Secondly, within emerging mar- tively low correlations between kets there are excellent opportuni- emerging markets and developed ties for adding value through markets compared to those stock selection. One of the main between developed markets them- drivers of most emerging markets selves. For example, the 15-year is foreign fund flows. Overseas correlation between the S&P 500 investors tend to focus their atten- Index and the FTSE 100 Index is tion on the representative and 0.73 compared to 0.61 between the larger capitalisation stocks within MSCI Emerging Markets Index and each market. These represent bet- the FTSE 100. Further, correlations ter-researched, more liquid invest- within the emerging markets uni- ments, but by the same token they verse are significantly lower than are usually well known stories and those within that of the developed their stock is often fully valued. markets. Consequently, skillful Consequently, the most attractive asset allocation between emerging investment opportunities can markets enables investors to focus often be found outside the larger on those markets where the names for those investors who are growth and corporate profiles are prepared to expand their invest- best for any stage in the economic ment horizons and research cycle. For example, strong global efforts accordingly. growth and trade may well lead to Thirdly, emerging markets often greater outsourcing by first world present greater opportunities than companies, and prime beneficiar- developed markets by virtue of ies of this trend such as India and China could be overweighted. On “IN GLOBAL PORT- the other hand, when commodity prices are rising Russia and Brazil FOLIOS INDIVIDUAL might look more attractive. To EMERGING MARKETS illustrate, a recent example of an OFTEN REPRESENT opportunity to add value through RELATIVELY MARGINAL asset allocation: over the first POSITIONS. quarter of 2008, the MSCI World CONSEQUENTLY, fell by 9.0% in US dollar terms; the FOREIGN INVESTORS MSCI Global Emerging Market Index also fell 10.9%, but within CAN BE VERY HEAVILY the index there was startling OVERWEIGHT” EMERGING MARKETS 37

“COMPARED TO DEVELOPED MARKETS, LOCAL INSTITUTIONS ARE USUALLY MORE MARGINAL PLAYERS IN THE MARKET; DOMESTIC INSURANCE FUNDS, PENSION FUNDS AND ALIKE ARE OFTEN IN THEIR INFANCY” their greater volatility. On a five- contributes to volatility. year view the standard deviation Retail investors tend to invest on of returns of the MSCI Emerging newsflow, often trying to pre-empt Index is 5.4, compared with a foreigners. They often lack a deep figure of 2.8 for the MSCI World understanding of the underlying Index, or 2.6 for the S&P 500. fundamentals, global forces and Some of this volatility can be company prospects. They often accounted for by greater fluctua- trade using borrowed funds, tions in underlying economies, possibly on margin, and thus have currency movements, or is just a a limited capacity to endure FIVE function of market size, but an losses. As a result, stock prices additional factor is the way the tend to get pushed to the limits of market works. In global portfolios valuations, both on the upside individual emerging markets and the downside. Such volatility often represent relatively mar- presents opportunities for the ginal positions. Consequently, for- cool-headed, well-researched and eign investors can be very heavily longer-term investor to pick just overweight or cut exposure to the right moments to buy and sell. nothing depending on market The prospects for the emerging attractiveness at any specific time, market asset class look good, and and this can result in some there are significant opportunities extreme money flows. to outperform. The key for the Local investors too can be some- foreign investor is to structure an what fickle in their investment investment approach to take full activity. Compared to developed advantage of the considerable markets, local institutions are opportunities that currently exist. usually more marginal players in the market; domestic insurance Peter Jenkins is an investment funds and pension funds are often specialist at Nomura Asset in their infancy and hence do not Management UK have the same overall clout and are correspondingly less of a sta- SPONSORED BY bilising influence on the market. This leaves retail investors as more significant players than is the case in developed markets, and this See page XX for contact details emerging markets Investors debate decoupling theory Ever since shadows from the US subprime crisis began to lengthen over markets, investors have begun to wonder how much truth there is to the theory that less developed markets are no longer closely correlated to developed markets. Caspar Hoare tests the theories

he debate is critical for investors because if emerging markets are still not correlated, they may be able to provide relative and absolute outperformance even given the other risks usually associated with the asset class. Problem number one: there is no single definition of what an emerging market is any more. Somewhere Tbetween under-developed and developed, it may have a basic financial infrastructure in place, but lack liquidity and trusted regulation. Politics invariably features. One commentator defines an emerging market as one where “politics matters as least as much as economics”. The upside is the faster economic growth derived Jerome Booth: time to from younger populations spending, saving and paying add alpha taxes. Emerging markets have delivered strong gains to savvy investors who engaged at the beginning of the dec- the de-coupling theory is overdone. McDonnell, who ade. “Emerging market returns have been phenomenal has advised both Shell and IBM pensions teams, in both absolute and relative terms,” says Todd Henry, believes pension funds will benefit from a dedicated portfolio specialist on emerging market equities at T. and significant long term allocation. “I can see an Rowe Price. “Investors have been reaping around 38% argument for having as much as one third of an equity returns annualized for the past five years.” allocation in emerging markets,” he says. “That’s a big Jerome Booth, head of research at emerging mar- jump from where allocations are today at 3% or 4%.” ket specialists Ashmore, asserted in December that So what makes the institutional investment industry emerging equity markets were de-linking from devel- so sure that emerging markets will deliver? National oped markets, and that they would perform not only economies have become more integrated through differently from developed markets, but better. “Now trade, foreign investment, capital flows and migra- is the time for the active top-down macro manager of tion, suggesting that a recession in larger economies emerging equity,” he says. “The more the global mar- will pull down smaller ones with them. ket disruption and volatility, the greater the ability of In January of this year, the MSCI Emerging Market the macro-manager to add alpha.” index dived as the subprime contagion swept through T. Rowe Price’s Henry agrees that there has been Europe and central banks moved to cut interest rates. a decoupling. The allocation of the firm’s flagship Then, in early April, Ben Bernanke, Federal Reserve Chair- emerging equity product, weighted in financials, real man warned the US Congress of a possible US recession. estate and consumer, bears that out. But he cautions John Pollen, head of emerging market equities at that returns from emerging markets will not be as Pioneer Investments, argues that despite a poor Janu- hefty as they have been since 2000. ary performance, emerging markets proved extremely However Joseph McDonnell, head of Morgan resilient to the subprime crisis compared to the wider Stanley’s Global Portfolio Solutions division, thinks market. The index was pulled down with the rest of

globalinvestormagazine.com April 2008 25 emerging markets

the market in mid-August argument,” says David da Silva, global emerging mar- David da Silva: and then simply rebounded ket product specialist at Nomura Asset Management. strong emerging as sharply as it had fallen to Mark Roxburgh, head of Nomura’s marketing and market trade resume its climb through the client services, says the voracious appetites of new growth rest of the year. Since then ‘middle-class’ demographics, will offset the effects the index has continued to of any slowdown. According to Euromonitor Inter- outperform the MSCI World national, the Chinese middle class grew from 65.5 Index. million to 80 million in the two years to January 2007, Ashmore’s Booth notes and is expected to reach 700 million by 2020. that decoupling should not That demographic trend has the power to support be confused with short term real economic growth. Domestic consumption rose detachment. “Short term almost three times as fast as in the developed world, moves are still correlated to and according to HSBC, real capital spending rose global markets in most cases,” by 17% last year compared to 2.1% in rich economies. he says. Emerging markets Nearly all (95%) of China’s growth came from domestic continue to be a high volatil- demand. “This substantially larger middle class with ity asset class and emerging higher disposable incomes will ultimately transform equities will not be immune to the Chinese consumer market for the benefit of retail- sudden movements in world ers and banks, among others,” says Pioneer’s Pollen. markets. With urbanisation, developing nations have to invest But it’s the mid to long-term in massive infrastructure building programmes. This potential in emerging markets in turn supports further inter-emerging market trade. that asset mangers are bullish Most emerging market revenue derives from raw mate- about. They believe that the long term economic engines rials and energy exports. China and India’s insatiable that drove returns higher since 2000 are still powered up. demand for oil is a boom for commodity driven econo- Pioneer’s Pollen points to the series of economic mies like Brazil, whose exports soared by 26% in the reforms that many emerging countries implemented year to February. Infrastructure also promotes further from which they are benefitting today. After the down- productivity, and in turn, further economic growth, and turns in the 1990s, emerging nations sought to manage that benefits investors in the long run, says Pollen. their debt better and build up significant reserves through active currency market intervention. Most now enjoy a Hazards trade surplus and large currency reserves, which help The risks associated with decoupling are difficult to cushion their economies from external shocks. identify and to time. Commodity prices are seen as one The surpluses enable central banks to give the econ- hazard. China’s growth is currently propping up prices omies a fiscal stimulus if foreign investment slows, or – it accounts for a third of the increase in oil demand dries up. Improved monetary policies have also helped since 2003, and 66% of additional copper and alumin- create low inflationary environments conducive to ium demand. A downturn in the Chinese economy could private market long-term real investments. hurt commodity exporters more than a US recession. Booth believes emerging market currencies will Others warn that much of China’s consumption is appreciate as the dollar weakens. With stronger used for processing into exports, leaving it exposed domestic demand and greater fiscal and monetary to the global consumption cycle. One commenta- control, stronger economies are inevitable, and in his tor said that a 3% drop in China’s growth rate to 8% view will drive equities higher. could remove the supply deficit from energy markets and send most industrial metals into surplus, hitting Trade growth emerging exporters hard. Trade among emerging nations is another major driver There has already been something of a correction, for economic growth. Significantly, it is at the expense according to Henry at T. Rowe Price. The price spreads of trade with developed countries. The top eight emerg- between emerging markets and developed ones have ing markets now contribute the same to global growth narrowed and in some measures, there is a slight pre- as the entire G7, and Booth reckons that a US recession mium. But Ashmore’s Booth maintains that growth could slow emerging market growth to 8%. in China, at least, still justifies the price: “Insofar as Compare this to the European Commission’s 2008 the markt is pricing in, and companies are delivering forecast for GDP growth in the Euro area of 2.2% and stronger earnings growth in ermerging markets than 2.4% in the EU. Both emerging markets and the EU in the developed world, then there is no bubble.” have around 30% of global GDP share. He also advises that volatility in emerging markets Exports from China, acknowledged as the global is approaching developed market levels. Nomura economic powerhouse, to Brazil, India and Russia, warns that investors who rode the bull market since the next three largest emerging economies, were up by 2000 have started to bank profits, creating a new more than 60% in 2007 and those to the Middle East source of volatility. “Those who have reaped strong by 45%. However, China’s exports to the US slow sig- returns over the last five to 10 years will be tempted nificantly in the year to January. Emerging markets as to take their chips off the table to fund different com- a group now export more to China than to the US. mitments. They may also be resetting their allocation “While developed markets still exert a huge influence targets,” says da Silva. “However, a lot of new alloca- on emerging markets, we believe that intra-emerging tions are being made, which is dampening the effect market trade growth stongly supports the decoupling of a sell-off.” g

26 April 2008 globalinvestormagazine.com www.globalpensions.com emerging markets April 2008 27

or equal to that of single manager global funds. Oliver Wyman attributes this to two diversifying Taking a regional approach effects: firstly, the larger number of holdings relative to a global fund, and secondly, beneficial diversification due to the more “local” to emerging markets nature of regional EM holdings. One attribute of emerging markets Emerging market equities are now a collection of regional strategies is that their correlation with devel- seen as a mainstream asset class imply in terms of likely returns, oped markets is increasing and this that many would see as having an volatility and costs? Whilst it is primarily a function of the larger importance far beyond their cur- may seem intuitively obvious stocks in the indices, which may be rent capitalisation weightings in that regional managers becoming more closely tied to their the MSCI index. Not only has the should have more spe- global sector peer groups. Regional performance of the equity markets cific expertise than their managers with more expertise to over the last five years been spec- global counterparts cov- invest outside the MSCI universe tacular, but in addition, the globali- ering the same region, are therefore more likely to benefit sation of international trade has does the evidence from the diversification benefits of led to drivers of sustained growth really support this? investing in numerous companies becoming structurally imbedded Oliver Wyman’s study overlooked by international global across a vast swathe of emerging examined these issues investors because they do not pass countries across the globe. The using a statistically through market capitalisation and long term high GDP growth robust and defensible liquidity screens. rates this implies will ensure the approach to produce global emerging markets will only results that carry a high Composites emerge the increase in importance in equity degree of credibility. winners portfolios. However, with over The emerging market Combining the return analysis with 15,000 listed stocks in the universe universe can be broadly the risk analysis provides an even and over 900 in the MSCI Emerging split into the Asia Pacific more stark comparison of the trade- Markets index across 25 countries, region, which covers offs between above average quar- managing a global emerging mar- around half of the tile composite portfolios of regional kets portfolio is an ambitious task. capitalisation, Latin funds versus above average global Not surprisingly, a recent research America and Emerging managers. The above average report by Oliver Wyman commis- Europe together with global managers had higher sioned by Nomura Asset Manage- South Africa. Oliver Wyman’s tracking errors than average global ment (Emerging Markets Product study examined a universe of just managers, which can be attributed Analysis, February 2008, Oliver over 1,000 funds. After eliminating a valid approach for comparisons to taking on higher risks to achieve Wyman) found 72% of the nearly single country funds, duplicate of risk. A statistically robust com- higher than average returns. 200 global emerging market funds funds, non-equity funds, misclassi- parison required creating a set of However, the composites of above examined underperformed the fied funds and funds with less than global composite funds based on Joseph average regional managers had MSCI EM index over a seven-year a three-year track record or assets random selections of managers. no increase in measured tracking period. For institutional investors of less than US$5m, they were left First of all, one fund was randomly Mariathasan errors compared to the composites seeking to raise their weightings with just over 400 funds. Of these, selected from each region and the reports on the of the average managers. Whilst the to emerging markets substantially, 47% were global, 28% Asia Pacific, returns weighted as per the MSCI results of a reasons may be debateable, the con- the situation is even more dire, as 16% emerging Europe, 9% Latin weightings to build an example clusions are clear, as Oliver Wyman the historically best performing America and 1% South African. of a hypothetical “global compos- recent study, pointed out: “A composite fund con- managers are often closed to new Using net returns for all the funds ites fund”. The monthly deviation which would sisting of top regional managers business, or in some cases, should produced a level playing field for of the composite fund from the outperforms top global managers by be even if they are not already. analysis, whilst great care was also MSCI global EM index was calcu- seem to show 2%, whilst achieving a significant Anecdotal evidence suggests the taken to deal with other complica- lated and the standard deviation composite funds decrease in tracking error.” Given experience of falling from top quar- tions. Finally, they rebalanced the taken to give the monthly tracking that new investors may often not tile to fourth quartile within a year regions on a yearly basis according error (annualised to give the more grouping regional be able to access new capacity for of closing a fund to new business is to the MSCI weighting for each year, familiar tracking error figure). managers can their investments at top global man- not an uncommon occurrence. It is which raises the issue of whether This process was then carried out agers, the choice of a collection of top clear many previously successful global fund managers are able to multiple times to produce a set of prove a better regional managers does not appear managers have gone down the route add value through tactical asset composite funds, enabling analysis emerging markets to be a second rate alternative and is of asset gathering at the expense of allocation across regions, with little of the average tracking error of this investment option arguably a superior choice. performance in markets that can evidence to support this. data set to be carried out. Selecting and managing a port- be heavily capacity constrained The analysis looked in detail at for pension funds folio of regional managers is with the inevitable degradation in Balancing risk and return the risk profile of composite port- than investment therefore conceptually attractive. returns. The return comparisons stand out folios of regional funds compared However, for institutional investors But what are the alternatives quite clearly in the Oliver Wyman to global funds. On a stand alone through one with relatively small weightings to for gaining exposure to the global analysis. The composite fund com- basis, the regional managers exam- global manager emerging markets, it is an expensive emerging markets? Choosing a prised of the top quartile regional ined had a larger tracking error and onerous task. Multi-manager second or third tier global man- managers outperformed the global than the global funds, with an solutions are becoming available, ager that happens to be open for top quartile average in six out of average tracking error of around although the typical model implies business is an unattractive option. the last seven years. Moreover, the 7.9%, whilst single manager global a double layer of fees. One alter- But there is another route. That is excess return of the composites funds had an average tracking native that may become increas- to choose a collection of regional over the global was over 2% p.a. error of 5.0% over a five-year time ingly attractive is for groups of top managers that combined can give The question that any institutional period. The global fund tracking tier regional managers to package a global exposure. There are many investor would pose, however, is errors were also consistently lower their products into a global solution top tier regional and country man- whether the excess return seen in than regional funds over the one, on a co-operative basis with just a agers with capacity to spare, as the a portfolio of top quartile specialist three, five and seven-year time- single layer of fees. Such products demand for regional managers his- regional funds has been produced frames. Oliver Wyman suggested open up new capacity in emerging torically has been far less than for through having greater risk against one rationale for this could be the markets through utilising top tier global. This is clearly a strategy the benchmark than top quar- differing investment strategies, as regional fund managers. If, as many of the largest institutional tile global portfolios? To answer regional funds are more likely to For more on Oliver Wyman’s study has shown, investors are already adopting, this question requires great care invest in more volatile small and emerging markets they also have better return and but it is also a strategy that even to ensure statistical robustness. mid cap stocks which would often go to: risk profiles than existing top tier, smaller schemes should consider Whilst the composite global fund be outside the MSCI universe. How- globalpensions.com let alone second tier, global man- seriously and the rise of multi-man- returns analysis used the average ever, on a composite basis, the differ- agers and in addition have similar ager solutions can open up cost of the regional manager returns, ence in tracking errors disappeared fee levels, they would seem to be an effective ways to do this. But for this inherently strips out some of and the average tracking error attractive choice for new investors institutional investors, what does the volatility, so it does not provide for composite funds was smaller into emerging market equities. 28 April 2008 Sponsored article www.globalpensions.com Emerging markets focus

forecasting that investment plans KOREA: Steady outlook ahead for manufacturers would increase Since midway through last year, as represented by the Dow Jones remained relatively strong. The by about 15% in 2008. Overall, the ongoing crisis originating from Industrial Average has lost 12% of adverse impact of the expected although Korean economic growth US sub-prime mortgage lending its value. In comparison, the South slowdown in US economic growth could decelerate in line with the and its dramatic impact on the Korean equity market, represented on exports could also be offset slower global economic growth, we Eric Poh is employed global credit markets has effec- by the KOSPI, has lost an even somewhat by the strong economic believe it is likely to remain rela- by Nomura Asset tively undermined the performance greater 17% of its value in the same growth and continuing demand tively steady. Management of major equity markets around the period. from China. As seen below, China Although South Korea’s eco- Singapore Limited world. The economic impact of this However, unlike the situation in and Europe have overtaken the US nomic fundamentals seem resilient, (NAM Singapore), the crisis, on top of the slide in US real the US, the South Korean economy as the main destinations for South the historical correlation between appointed fund manager estate prices, has shattered con- remains quite resilient. As shown Korean exports. the South Korean and US stock to the Emerging Asia sumer confidence. Hence domestic by Chart 1, economists have rushed Second, the domestic economy is markets remains relatively strong. portion of the Nomura consumer demand, which accounts to downgrade US economic growth expected to improve, mainly due to Given the cautious outlook for the Funds Ireland Plc for the bulk of the US economy, is forecasts over the next two years. On the recent change of government. US stock market in the near term, – Global Emerging expected to slow down if it has not the other hand, the downgrades to For several years, domestic sen- this might affect the performance Markets Fund already done so. forecasts of South Korea’s economic timent has been weak due to the of the South Korean equity market. In the four months ending Feb- growth are still relatively mild. previous administration’s harsh Nevertheless, other factors are ruary 2008, the US equity market Unfortunately, it seems that anti-speculative measures tar- still relatively supportive. First, investors have been indiscrimi- geted at the property market. With equity valuations are attractive, Chart 1: USA economic growth nately reducing their exposure property prices being depressed, with South Korean stocks trading to the equity markets with little domestic spending has been cau- at a price to 2008 earnings ratio of regard for the fundamentals. If tious. With the election of the new about 11.9. This compares favour- we look at the fund flows, foreign president, MB Lee, these restrictive ably with the US equity market, investors have been the main sellers policies are likely to be reversed. which is trading at a PER of about of the Korean equity market. Over As a former CEO of Hyundai Engi- 13.2 based on 2008 earnings. the past four months, foreign inves- neering & Construction, president Second, domestic investor senti- tors have reduced their exposure to Lee has a pro-business mindset ment remains positive. As the chart the Korean equity market by about and is well known for his market- below demonstrates, domestic US$20bn, bringing foreign owner- oriented policies. Indeed his elec- retail investors are pouring signifi- ship levels from 32.5% as at the end tion campaign focused mainly on cant assets into the Korean equity of October 2007 to 30.9% as at the economic issues. As a result, he is markets. Source: Consensus forecasts end of February 2008. Historically, very likely to implement measures This trend is expected to con- the correlation between the US and to boost domestic demand. How- tinue in the near future as many of Korean equity markets has been ever, it is important that his Grand these retail investors have chosen Chart 2: South Korea economic growth strong. Moreover, global inves- National Party wins a majority in to invest through regular saving/ tors still continue to view Korea as the upcoming parliamentary elec- instalment plans. At the same time, an emerging market (associated tion in April this year so that he can the low birth rate in South Korea, with greater risks). As a result, the implement his policies effectively. which will result in an ageing pop- Korean equity market has suffered In addition, due to his back- ulation, has highlighted the need heavier losses than the US equity ground, the new president has a for people to invest for their own market. strong relationship with major busi- retirement. In other words, the pro- Looking ahead, we still expect ness leaders. He is likely to use his file of retail investors seems to be the Korean economy to stay resil- influence to push Korean companies changing. Whereas they tended ient, despite what many analysts to increase their fixed investment, to invest in the equity market for believe could turn into a global which has seen lacklustre growth short term gains in the past, they Source: Consensus forecasts slowdown. over the past few years. Already, are now looking for more sustain- First, export growth has so far the Korea Chamber of Commerce is able returns over the long term.

own man, there seems to be a good Russia: Life in the old bear yet chance that his actions and policies Investors who backed president of the average Russian, even though bureaucracy, lowering taxes and will be designed to extend rather Putin when he assumed power in the extent to which his actions have investing in infrastructure; all than reverse the developments that John Dawe is employed 2000 through an investment in been responsible for this renais- music to investors’ ears. have supported Russia’s stock- by Charlemagne Russian equities have been hand- sance is debatable. The quadrupling Such statements also provide market over the past eight years. Capital (UK) Limited, the somely rewarded over the past of the oil price, which has poured some comfort in respect of the tran- However, it is wrong to suppose appointed fund manager eight years, both in absolute terms money into the state coffers, may be sition from Putin to Medvedev. that a change from like to like will to the EMEA portion and relative to investments in other a rather more important factor. There remains some uncertainty as result in little change in economic of the Nomura Funds emerging markets. As the accom- But now, as Putin hands over to how power will be shared, given policy over the short term, for other Ireland Plc – Global panying chart shows, the MSCI the reins of power to his protégé, that Putin is favoured to take on forces are at work which may require Emerging Markets Fund Russia Index has grown seven-fold Dmitry Medvedev, investors in the position of prime minister. The significant changes. Unfortunately, over this period, outpacing Brazil, emerging markets, who always consensus is that Putin will con- just as Putin inherited an economic China and India. need to keep half an eye on polit- tinue to wield considerable power situation that could only get better, This performance has come ical developments, are rightly con- and influence, at least initially, and so Medvedev is faced with an eco- against a backdrop that has seen cerned that nothing should get in that Medvedev will not step out nomic situation that, over the short the Russian economy bounce back the way of further gains for Rus- of line. But as Medvedev finds his term at least, looks set to deteriorate. from the debt crisis of 1998 to record sian share prices. feet and grows into the position of Inflation is rising as global demand GDP growth rates averaging almost Medvedev, for his part, has been president, this situation could cer- for energy and commodities pushes 7%, with inflation falling from 85% making all the right noises to reas- tainly change over time, much as prices for such goods ever higher, in 1999 to a low of less than 8% in sure investors. At the Krasnoyarsk Putin himself cut loose from his whilst at the same time global eco- 2007 (though in common with other economic forum on 15 February, he predecessor, Boris Yeltsin, who nomic activity has faltered in the economies, inflation has since risen). unveiled his economic programme also handed him the presidency on wake of the sub-prime crisis. This has also been coupled with and was at pains to project an a plate. Of course there will always With no further national elections strong current account and budget image of economic liberalism, sup- be doubts as to the extent to which scheduled for almost four years, eco- surpluses. Naturally, Putin has been porting the continued develop- positive pre-election rhetoric will nomic policy can now be refocused heaped with praise for this achieve- ment of a market-based economy. be carried over to the post-election away from simply pleasing the elec- ment, which has seen a significant Medvedev specifically mentioned period, but should Medvedev break torate and towards more meaningful improvement in the living standards promoting the rule of law, cutting free from Putin and become his structural reform. Given the extent www.globalpensions.com Sponsored article April 2008 29

Rising food prices mark return of agflation In 1798, the Reverend Thomas of meat. In emerging markets, con- number of specialised commodity tial to do this, for example, in Brazil, Malthus suggested that a growing sumption of cereals has stabilised, products launched in 2008, high- Russia, Kazakhstan and parts population, increasing at an expo- but demand for meat has doubled. lighting that commodities offer of Africa, although water supply nential rate, would eventually be The net effect is that farmers now returns not correlated with stocks continues to be a limiting factor checked by the limitations of its feed about 200-250 million tonnes or bonds. in many areas. In the meantime, resource base. In fact, the cata- more grain to their animals than With the price of wheat and soy- higher food prices will distribute strophic situation he envisaged has they did 20 years ago. beans at record levels in February costs and benefits unevenly. Rising not come to pass on a global scale. At the same time, the rising 2008, and global food invento- prices affect those with the lowest The application of technology in oil price and concern about the ries at multi-year lows, it is fair to incomes disproportionately, as indi- population control and agricultural warming effect of carbon dioxide assume that farmers will respond viduals have to spend a higher per- intensification has made it possible emissions has prompted a policy by increasing planting. According centage of their income meeting for us to feed a population now focus on biofuels. In theory, bio- to the International Food Policy basic needs. In the US, food makes estimated to number 6.6 billion. We fuels produce lower net emissions Research Institute, a 10% increase up around 10% of an average fam- have become adept at increasing of carbon dioxide than energy gen- in price should yield a 1-2% ily’s consumption basket. In sub- yields, and the International Grains erated from burning fossil fuels. In increase in supply. Saharan Africa, the figure is 60%. Council estimates that total output fact, the situation is far from clear The need to increase agricul- Concern about this has prompted reached record levels in 2006, sur- as the UK-based science body, the tural output does raise some major many countries, including Argen- passed again in 2007. If total agri- Royal Society, has published a policy issues. One, which the Euro- tina, Mexico, Russia, Morocco, Mary Ziegler is employed cultural output is increasing, why report suggesting that some bio- pean Union has failed to address, is China and Egypt, to introduce some by Gartmore Investment are agricultural commodities rising fuels could have a higher carbon the potential of Genetically Modi- form of price controls. Management Limited, so sharply in price? cost, due to the fertiliser and energy fied Organisms (GMOs) to enhance At the same time, the world’s the appointed fund Global food prices have jumped used in production and processing. output. For some time, biotech- food producers should benefit. manager to the Latin 75% since 2000. Both demand and In 2007, US president George nology companies such as Mon- At country level, exporters such American portion of the supply-side factors are contributing Bush signed legislation requiring a santo have insisted GM products as Brazil, India and South Africa Nomura Funds Ireland to ‘agflation’. On the demand side, five-fold increase in biofuel produc- can help increase yields substan- should gain, with benefits weighted Plc – Global Emerging many emerging economies have tion by 2022, backed by a complex tially. It believes the yield grown towards rural rather than urban Markets Fund moved from subsistence-dominated subsidy scheme. Some land previ- from maize produced in the US areas. Major food importers such agriculture, where farmers grow ously used for food production, for could double by 2030, with genetic as the Gulf states and Japan will produce for their own consumption, the production of wheat and soy- modification enhancing features pay more. At micro-level, rising to more sophisticated, specialised beans, is being utilised to cultivate such as crop resistance to disease farm incomes give farmers the supply arrangements. At the same maize for ethanol. South American or drought. While the EU stalls, opportunity to invest and increase time, food consumption patterns neighbour Brazil has also made the area of GM crops under cultiva- yields. The potential for companies have changed. significant progress with its bio- tion is growing fast in the emerging offering agricultural technology is Demand has shifted away fuel strategy, using sugar cane in markets, including Latin America. evident, from those offering basic from basic calories, such as those ethanol production. It produces According to International Service mechanisation to more sophisti- obtained from largely vegetarian more ethanol per hectare than the for the Acquisition of Agri-biotech cated applications. diets, towards those obtained US maize-based schemes. It has, applications, Brazil, Argentina, These trends offer opportunities through more protein-rich consump- however, been criticised for forcing Uruguay and Paraguay all have for investors, but also suggest some tion. Meat production is highly deforestation, pushing ranching millions of hectares in production. major policy challenges. Access to grain-intensive, which means one and soybean production further In Brazil, planting increased from water will be a critical issue, one obtains fewer calories from con- into the interior of the country. a low base by 30% in 2006-07. that may have to be balanced with suming a kilo of meat compared to In addition to demand and supply- Industry consultant Cropnosis sug- strategic decisions on food security. the energy obtained from the grain side factors, the market mechanism gests the market for agri-biotech- There is an urgent need to enhance used in its production. It takes itself may be contributing to food nology more than doubled in value yields, but concerns over the safety around four kilos of grain to pro- price inflation. At a time of vola- between 2001 and 2006, and could of genetic modification still linger. duce a single kilo of pork. Beef is tility on the world’s financial mar- reach US$8.4bn by 2011. These complex issues are becoming even more demanding, with a cow kets, hard and soft commodities For global consumers, it will take the most critical in global agricul- having to consume an average of have had more investor attention. time to bring additional agricultural ture since the ‘green revolution’ of eight kilos of grain to deliver a kilo There has been an increase in the land into production. There is poten- the 1960s. of his victory in the presidential elec- faster rates than Russia’s, par- of both physical transport links and tion, Medvedev now has a window ticularly over more recent years; a stronger legal system, and a more Chart 3: GDP growth rates (percentage forecast post 2006) of opportunity to introduce changes GDP growth rates have also been dynamic business sector that relies that in other circumstances, and at stronger in some of the other coun- less upon the state-like control of the other times, could prove politically tries that comprised the former behemoths of Moscow and St Peters- impossible. He also has a free hand Soviet Union, such as Kazakhstan burg and rather more on a growing to take action in response to the and the Ukraine (see accompa- number of more efficient small and current situation, action that could nying chart), many of which do medium-sized enterprises, fuelled entail a reversal of the previous tight not share Russia’s wealth of nat- by competition. In this way, Russia fiscal and loose monetary policy, as ural resources. Indeed, outside the could emulate other emerging mar- interest rates rise to meet the chal- energy and materials sector, the kets that have less historical bag- lenges of inflation and government Russian economy has little to show gage and are more fleet of foot. We spending is directed more towards for itself on the world stage; it still, can again draw some comfort in this the infrastructure investment that for example, produces no manufac- respect from Medvedev’s Krasno- Source: IMF world economic outlook the economy so badly needs. The tured exports of any significance. yarsk speech, in which he proposed recent transformation of the Stabi- One only has to travel outside the reforms targeted both at devel- lisation Fund into the Reserve and main centres to seemingly travel oping domestic capital markets and Chart 4: Stock market performance (MSCI indices, USD net total return) National Welfare Funds, to receive back in time, to appreciate the improving conditions for the devel- some of the tax revenues arising potential for economic development opment of small businesses. from the oil, gas and other similar that still exits. After all, it is only Ironically, it is the fact that so industries, will go some way towards in the last couple of years that the much more remains to be done supporting a sustainable level of gov- level of GDP has returned to where that makes Russia such an attrac- ernment spending in the future. it was in 1991, the year the Soviet tive investment proposition at the Although Russia’s economic Union finally fell apart. moment. Russia still has enormous performance has certainly been It therefore seems likely the potential to reward investors, sig- impressive over the last eight years, Russian economy could see GDP nificant parts of the economy it could have been even better. Both growth of more than 10% a year, in remain underdeveloped, and those India and China have seen their the same league as China and India, who stick with it might well reap economies grow at significantly given better infrastructure in terms the return. Source: MSCI 31 EI Nomura MarApr08:Nomura 17/3/08 10:29 Page 18

EXPERT VIEW Global Emerging Markets David da Silva of Nomura Asset Management UK Limited explains the essentials of investing in GEMs

What is a GEM fund? What types of GEM fund are available? schemes overall, by including emerging GEM funds invest in stocks listed on GEM funds can be distinguished by the markets in the scheme’s investment line-up, stock exchanges in emerging markets, management structure in place. Many are although remember that in times of crisis frequently referred to as developing single-manager funds, where one firm covers correlations can rise significantly. As with all countries. Although there is no exact all the emerging regions with a single fund investments we would recommend that you definition of emerging markets, it is safe management team, each team member explore all possible risks before investing. to see these as being all the markets sharing either regional, country or sector outside the established developed responsibilities. This requires resources to How have GEM markets been affected by markets of North America, Europe, Asia ensure optimal coverage. It is a significant the recent stock market problems? and Australia. Although this includes a challenge to do well, given the diversity, on a Emerging markets fallen more sharply than broad cross section of countries around regional, country, language and economic their developed counterparts. Despite this the world, it is worth noting that market level. we retain a positive long term view on the capitalisation of emerging markets of the Another option is to choose fund of funds asset class based on strong fundamentals. global index is approximately only 11%, or manager of manager products. These can Emerging economies are now in a far as calculated by the MSCI Index*. GEM group together several global fund healthier economic position than they have funds attempt to capture the growth management firms into a single product ever been. Many economies now have potential across these markets by detailed taking into account each manager’s style current account surpluses, governments stock selection and country allocation. preferences. There can be several layers of have tightened fiscal controls and corporate The term ‘emerging market’ refers to fees to accommodate the managers and the debt remains at modest levels. Although for the stock market itself rather than to the product providers. There is also an option to the moment they are dependent on trade underlying economy. For example Korea, create a global product by grouping together with the developed world, we are already Taiwan and Israel are included in the regional specialists who focus on emerging witnessing emerging markets benefiting from emerging markets universe whereas on a countries in Asia, Latin America and EMEA rising domestic demand and growing trade number of criteria these economies could (Europe, Middle East and Africa). The between emerging economies. This be categorised as developed. This means intuitive appeal of grouping together three development will increasingly insulate them that within the investment universe a regional specialists, needs to be weighed up from any broader slowdown. broad range of underlying economies are against the governance costs required to That said, in times of severe market represented. This gives the fund manager monitor the managers. We have followed turmoil globally, such as in January 2008 the opportunity to invest in a very wide this regional specialist approach in investors will take profits where they are range of industries and themes. constructing our Nomura GEM product, and available and the strong performance of have found that regional specialists with emerging markets in recent years has How does it differ from other emerging their local knowledge and experience are created a lot of gains. In this sense the markets funds? well placed to uncover stocks likely to selling of emerging markets might be GEM funds differ from other emerging outperform that might not be obvious to characterised as ‘technical’ in that it is a market funds in that they can invest more generalist investors. pure market reaction and not an indication anywhere across the developing world. of more fundamental problems. Distinction Many other emerging market funds Is a GEM fund right for my pension should be made between economic and narrow the universe of available scheme? market decoupling. Markets tend to move investment to specific regions or Although emerging markets have together in any sell off but over time they countries. A popular option at present is outperformed developed markets over the should reflect the underlying earnings (and BRIC investing, focusing on the long term, they are characterised by greater economic growth picture) and we retain powerhouses of the emerging world, medium term volatility. It is important to strong bullish view on GEM fundamentals. Brazil, Russia, India and China. But there consider whether your pension scheme can are other options such as BRICS bear this higher risk. A key consideration *Morgan Stanley Capital International including South Africa, Chindia (China therefore has to be the scheme’s investment Emerging Market Index as at 31st and India), Latin America and the Middle time horizon. Generally we would consider December 2007. ■ East. In our view this narrowing of the that the investment horizon would have to universe excludes some of the exciting be at least 5 to 10 years, allowing the fund growth opportunities typical of less well to deliver enough of a return to compensate covered countries and regions of the for the extra volatility. This risk should also By David da Silva, CFA world. This is why Nomura Asset be considered in light of how correlated of Nomura Asset Management have concentrated on the emerging markets are to your scheme’s global option with coverage by three existing investments. Generally speaking Management UK Limited regional specialist teams, to capture as emerging markets have had a lower many investment opportunities as correlation with developed markets. There possible. can be valuable diversification benefits to

ENGAGED INVESTOR MARCH/APRIL 2008 31 Analysis

Nomura Asset Management investment specialist Peter Jenkins believes the whole structure of emerging markets means it is an area where disciplined investors can add value Where is the alpha? Investing in emerging market equities measure of the value added by a manager and Kuwait, where the market rose 9pc. rewarded investors with solid returns over and above movements of the market. Secondly, within emerging markets there in 2007 and has produced excellent Firstly, the global emerging market are excellent opportunities for stock selection. returns over a longer period (+390pc in universe allows for a much wider degree The main drivers of most emerging a five year period to the end of 2007). of diversification over and above that markets are foreign fund flows. Overseas Looking forward, the short-term outlook which can be achieved through a spread investors tend to focus their attention on the is somewhat cloudier. Newsflow from of investments across developed markets. representative, larger capitalisation stocks developed economies and markets will Emerging markets embrace a wide range within each market. Consequently the most likely determine market direction and in of countries in different geographical attractive investment opportunities can often any global market downturn emerging locations with different economic structures be found outside the larger names for those markets look ripe for profit-taking as and at different levels of development. investors who are prepared to expand their investors lock in profits wherever they have They range from giant resource rich investment horizons accordingly. them. For those investors that have been economies such as Russia and Brazil Thirdly, emerging markets present more well weighted in this asset class for any through to manufacturing based economies opportunities than developed markets length of time, there are temptingly big such as Korea; from countries at a very by virtue of their greater volatility. On a gains to be taken. It is for this reason that basic level of development to countries as five year view the standard deviation of in times of crisis markets move together; developed and wealthy as Taiwan; from returns of the MSCI Emerging index is 5.3 correlations tend towards one. relatively open economies such as Chile, compared to a figure of 2.9 for the MSCI In essence Nomura believes that, to those with much state intervention and World index or 2.6 for the S&P 500. Some over the longer term, equity markets restricted capital accounts, such as China; of this volatility can be accounted for by follow the growth of economies and and from states which have freely floating greater fluctuations in underlying economies, corporate earnings and both are likely exchange rates to those that actively currency movements or pure market size to be significantly greater in the case manage or even peg their currencies. but an additional factor is the structure of of emerging markets than in developed The case for diversifying portfolios the market. In global portfolios individual markets. From our studies we expect trend through emerging market exposure is emerging markets often represent relatively growth of 6pc-7pc per annum in emerging captured in the relatively low correlations marginal positions. markets, a figure two to four times greater between emerging markets and Consequently foreign investors can than in G7 economies. Against this developed compared to those be very heavily overweight or cut backdrop of robust growth, emerging between developed markets. For exposure to nothing depending market valuations remain attractive; the example, the 15-year correlation on their attractiveness at any forecast price/earnings ratio (PER) on between the S&P 500 index specific time; resulting in 2008 earnings is less than 11 times, only and the FTSE 100 index is some extreme money flows. slightly above the five year average, and a 0.73 compared to 0.61 between Local investors too can be substantial discount to developed markets. the MSCI Emerging Markets somewhat fickle in their Despite the fact the growth profile and index and the FTSE 100. investment activity. Compared valuations are attractive, and emerging Consequently, skilful asset to developed markets local markets have been receiving strong fund allocation between emerging institutions are usually more inflows we believe that they are still markets enables investors to focus marginal players in the market; under-represented in investors’ portfolios; on those markets where the growth domestic insurance funds, pension G7 investors and savers are structurally and corporate profiles are best for any funds and alike are usually in their underweight this asset class. This is all the stage in the economic cycle. infancy and hence do not have the same clout more surprising given that global equity For example strong global growth may and are correspondingly less of a stabilising indices generally carry neutral emerging well lead to greater outsourcing by first- influence on the index. market weights at well below 10pc. This world companies and prime beneficiaries This leaves retail investors as a more under-exposure augurs well for the future. of this trend such as India and China could significant factor than is the case in An additional attraction of emerging be over weighted. On the other hand when developed markets and this also adds to markets is the opportunity afforded to commodities are strong Russia and Brazil volatility. As a result stock prices tend to significantly outperform what we already might look more attractive. get pushed to the limits of valuations. Such expect to be an outperforming asset class. As a recent example of asset allocation volatility presents opportunities for the cool We believe the whole structure of emerging opportunities: from the beginning of the –headed, well- researched investor. markets means it is an area where 2008 to February 13, the MSCI World So not only do the prospects for the disciplined investors can add value over fell by 9pc in dollar terms, and although emerging market asset class look good but and above the movement of indices; they emerging markets on the whole have fallen there are also significant opportunities to can add alpha. Alpha is a measure of the more sharply, dropping 11pc. The only outperform within. The key for the foreign difference between a fund’s actual returns region where equities have risen over this investor is to structure an investment and its expected performance, given its period has been the emerging region of the approach to take full advantage of the level of risk against market indices as Middle East. Benefiting from high energy considerable opportunities that currently measured by beta. In this sense it is a good prices, gainers include Jordan, Oman, Qatar exist and to produce alpha.

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017_IW_Feb08_Nomura copy.indd 17 21/2/08 12:13:54 pm Interview

Stephanie Spicer talks to Nomura Asset Management global emerging markets specialist David da Silva about the challenges facing the market Safety in numbers Nomura Asset Management global emerging markets specialist David da Silva is the first to admit that managing a global emerging markets mandate is a challenge. With three main regions to choose from, 27 countries in the MSCI Index, many non-benchmark options, and over 900 stocks in the MSCI benchmark as at December 2007, it takes some covering. What is perhaps more of a challenge is getting across to investors just what they can expect from emerging markets. Da Silva acknowledges emerging market investing is frequently mentioned in the press as a source of strong but risky returns, and he believes it is important to define just what emerging markets encompass. 23 countries in the MSCI EM index, economies with rising levels of GDP Da Silva says: “Emerging markets however there are many other markets per capita. can broadly be defined as being those which do not meet the minimum “This has been accompanied by markets located outside the established requirements for index representation growing domestic demand within markets of North America, Europe, but contain investible opportunities. these countries and also by growing Japan and Australia. For ease of We have seen a significant increase trade links between emerging reference these can be considered in the weight of emerging markets in countries and the developed world and the stock exchanges of developing global indices, both from new entrants notably among emerging countries countries.” and from growing existing country themselves.” The point to note however, says da allocations. According to da Silva these markets Silva, is that what is being referred to “Highlighting this point is that the have typically been characterised here are the stock exchanges rather MSCI EM index has more than doubled by less efficient information flows in than the underlying economies of its weight in the MSCI World index terms of market fundamentals and in these countries and this can explain a in the past eight years. We see this terms of stock specific news, all as a few exceptions. For example, he says, percentage growing in response to the result of less comprehensive coverage Korea, Taiwan and Israel are included strength and breadth of the markets of stocks and sectors. in the emerging markets universe, involved.” He says: “Although it is true that whereas on a number of criteria these What investors want to know of the largest stocks are generally economies could be categorised as course is which countries will be well researched, this coverage is developed. entering the official indices in the not exhaustive and there are many He adds: “As a result within this future, so that they can be there opportunities to add value by those investment universe a broad range of investing ahead of the pack. prepared to research companies underlying economies are represented, Trustees may anyway be wondering more in-depth. Our emerging market from poor primary producers to how they need to perform – or philosophy is based on this premise, relatively prosperous modern outperform in emerging markets. that having the resource to specialise industrial economies. This gives the Indeed, in the current market can on stocks in emerging markets places fund manager the opportunity to invest they be expected to perform let alone an investor in the best position to add in a very wide range of industries and outperform? alpha. themes.” “Emerging markets have performed “Of course doing this with a Despite this da Silva says it is worth strongly versus developed markets in global remit is a challenge, so we noting that emerging markets only the recent past and we believe that this have employed a regional approach, have a combined weight of about outperformance is set to continue over whereby specialists run the respective 11pc of the MSCI World Index and the long-term based on the favourable regions Latin America, Asia and around 50pc of this capitalisation is economic fundamentals underpinning Europe, Middle East and Africa concentrated in the BRIC countries, i.e. these markets,” says da Silva. [EMEA]. It could be argued that taking Brazil, Russia, India and China. “Performance so far has been driven this a step further to employ country He says: “There are an additional by the rapid expansion of emerging specialists would also be beneficial,

18 Investment World Feb 2008 – A ProfessionAl Pensions sUPPleMenT www.professionalpensions.com

018-019_IW_Feb08_Nomura.indd 18 21/2/08 12:50:25 pm Interview

however we have reservations about need it most, however this probably corporate debt remains at modest the resource and governance structure holds for most equity investments.” levels. This picture stands in marked required to employ multiple country When it comes to where schemes contrast to the deteriorating positions managers to run a combined global and funds would have invested in we are witnessing in a number of the mandate.” emerging markets 10 years ago and developed economies. When we come to consider how the different the emerging markets “Although for the moment they are how emerging markets have been scene is today, da Silva says anecdotal dependent on trade with the developed performing in recent years it is hard to evidence is that allocations to emerging world, going forward we will see escape the fact that they have exhibited markets by institutional investors are emerging markets benefiting from more volatility than developed markets rising, although he concedes exact rising domestic demand and growing over the long run. While this is figures are hard to come by. trade between emerging economies. apparent if you look at a rolling five- He says: “In many instances pension This development will increasingly year standard deviations, da Silva says funds have granted their international insulate them from any broader it is probably more important from an or global managers the ability to slowdown.” investment perspective to consider how invest in emerging markets. And these That said, da Silva concedes in times much performance has been achieved allocations have assisted in delivering of severe market turmoil globally, such in conjunction with this risk. outperformance, so much so, that as witnessed in January, investors will The table below highlights the many schemes have opted to farm out take profits where they are available. returns and risk levels achieved on their emerging exposure to dedicated The strong performance of emerging the MSCI World, S&P 500 and MSCI managers to participate more in these markets in recent years has enabled a Emerging Markets Indices. The higher markets. lot of gains to be taken. the figure in the “Return per unit of “We think that in the UK pension “In this sense the selling of emerging risk” columns the better. funds currently have on average 5pc markets might be characterised as ‘technical’ in that it is a pure market reaction and not an indication of more fundamental problems. Distinction should be made between economic and market decoupling. Markets tend to move together in any sell-off but over time they should reflect the underlying earnings (and economic growth picture) and we remain optimistic,” he says. Part of this optimism stems from The return per unit of risk figures in emerging markets and that this what Nomura sees as its solution to above highlight that for a given level percentage is rising.” the challenges to the emerging markets of risk over 3 and 5 year periods an Recent research from Intersec fund manager. investor would get more return from an Research and Greenwich Associates “The greatest inefficiencies in emerging investment than for example supports the fact that there is a similar emerging markets exist at the the S&P 500 or MSCI World. trend in the US. However, it is wo at individual stock level – however Over one, five and 10-year periods these allocations are well below the country fundamentals must be to the end of January 2008, emerging levels indicated by GEM’s weight in supportive,” says da Silva. markets have outperformed their global indices, which suggests that “We believe that combining the developed counterparts by a current allocations could easily double skills of three specialist regional significant margin. if institutions wanted to match global managers, one for each region, should Over 20 years, since the inception of benchmarks. permit greater depth of research of the the MSCI Emerging Market Index in Da Silva and his team at Nomura region. This should produce a better January 1988, the index has delivered are optimistic going forward on understanding of the regional country a massive 895pc return, this is over emerging markets as an asset class, and stock influences and permit 450pc better than the S&P 500 return despite recent market turmoil. greater individual sector and company and a massive 650pc better than the “Emerging markets have been research to be conducted. MSCI World. Figures to end of January affected by the recent global market “ Greater focus should result in 2008. pullbacks and in recent weeks better information and this should “However, possibly of greater have fallen more sharply than their produce better decisions and in turn importance to many investors is that developed counterparts,” da Silva more alpha.” emerging markets have exhibited agrees. “Based therefore on our core a relatively low correlation to their “Despite this however we retain a emerging Asia competency we have developed market counterparts positive long-term view on the asset identified and hired Charlemagne and consequently there are clear class based on strong fundamentals. Capital as the specialist for the EMEA diversification benefits to be Emerging economies are now in a far region and Gartmore Investment harnessed,” da Silva says. healthier economic position than they Management for Latin America. “Although, it is true to mention have ever been. Nomura manage the product in that in times of crisis we often see “Many economies now have current London and in this way investors can correlations increasing, so in a sense account surpluses, governments enjoy the benefits of three specialist diversification deserts you when you have tightened fiscal controls and managers, but deal only with one.”

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EMERGING MARKETS

Russia, India, China and South Africa) funds, however, we consider that there is a risk that these funds focus on the most popular markets and might ultimately miss All about emerging opportunities from newly developing economies where the returns might be greater. Finally, one can go passive but we believe this means missing most of the opportunities that can be exploited by active managers.

markets investing IS NOW A GOOD TIME TO INVEST IN EM FOR THE FIRST TIME? Expert David da Silva answers all your questions We view emerging market investing as a long term strategy and we consider that now remains a good time to invest. Emerging markets in general have strong WHAT IS EXACTLY IS MEANT BY global trade. As a consequence we see that balance sheets and healthy corporate INVESTING IN EMERGING MARKETS? they will constitute an increasing share of earnings growth, although it is true that From an investment perspective, we global GDP, and this will be accompanied by valuations have risen over the past few consider emerging markets to be all markets increasing weight in global indices. From our years, we believe that long term valuations outside the developed economies experience many institutional investors are are still reasonable given the growth (predominantly the US, Canada, the largest structurally underweight emerging markets advantage. In addition emerging markets as European economies, Japan and Australia). and, as this improves to a more a share of global indices have been These are often classified by the major representative level, we foresee an increase in increasing and we expect this trend to index providers into emerging market the demand for emerging stocks. So we see continue, providing a long term technical indices, however these listings invariably strong long term reasons for emerging market support for new flows into the asset class. only capture the top stock markets in terms investment both from a fundamental and a To put this in context, in the MSCI All of liquidity and turnover. There are many technical viewpoint. Country World Index for example, emerging other markets which don’t meet the countries have a weight of around 11%. minimum requirements for index WHAT SORT OF PENSION FUNDS IS EM This compares with Japan at 9%, as an representation but contain investible INVESTING MOST SUITABLE FOR? (IE example. opportunities. In general, emerging WELL FUNDED OR IN DEFICIT, STRONG markets tend to be rapidly expanding SPONSOR OR WEAK SPONSOR, PRIVATE WHAT QUESTIONS SHOULD I ASK A economies, albeit that they are starting SECTOR OR LOCAL AUTHORITY) PROSPECTIVE EM INVESTMENT from a low base, and are characterised by A pension fund that invests in the emerging MANAGER? low, but rising, levels of GDP per capita. markets should be able to bear a greater Managing a global emerging market volatility than that in developed markets. This mandate is a challenge for any manager. WHAT IS THE DIFFERENCE BETWEEN translates to an investment time horizon of at This is on account of the complexity and INVESTING IN NON-EMERGING least 5-10 years; over this period, the diversity of the markets included in the MARKETS? IS IT MORE RISKY? portfolio should be able to deliver enough universe. For example in the MSCI EM Emerging markets tend to exhibit greater return to compensate for the volatility. Having Index there are 27 countries spread across volatility than developed markets. However said this, the declining correlation between three distinct regional groupings with their strong returns on long term risk adjusted emerging markets and the rest of the world own languages, cultures and political basis have justified their inclusion in could make them suitable for diversification considerations. Acknowledging this, we investment portfolios. In addition, purposes, reducing the risk of the total believe that a global mandate is best emerging markets offer diversification portfolio of the pension fund. We believe that handled by a combination of regional benefits for investors in developed markets. an investment across emerging markets specialists. The following are key issues to globally, rather than single countries/regions consider when selecting an emerging IS INVESTING IN EM SOMETHING can yield more diversification benefits for the market manager. Do they have proven TRUSTEES SHOULD CONSIDER AS A investor. emerging markets experience? Do they have SHORT-TERM OR LONG-TERM STRATEGY sufficient resource to cover the markets and AND WHY? WHAT ARE THE DIFFERENT WAYS OF stocks adequately? Do they have We would advocate that investing in GOING ABOUT INVESTING IN EM? appropriate regional and global coverage? emerging markets is a long term strategy. When investing in emerging markets you About 80% of the world’s population could invest directly into companies listed on resides in emerging countries, while their local stock markets. You could hire a global By David da Silva, CFA Global Emerging Markets share of global GDP is still very low at less emerging markets manager, or alternatively, Product Specialist than 40%, according to figures released last given the diversity of these markets, you year by the Economist and the IMF. We view could consider hiring regional specialists to Nomura Asset Management that this imbalance will be addressed going cover the three main regions: Emerging Asia, U.K. Limited forward, as developing countries embrace EMEA (Emerging Europe, Middle East and market friendly policies, improve fiscal and Africa) and Latin America. Other alternatives corporate governance, increase education are to opt for specific country exposures, and skills levels and participate more in sometimes combined into BRIC(S) (Brazil,

ENGAGED INVESTOR TRUSTEE GUIDE TO RETURN SEEKING INVESTMENTS 2007 13 www.globalpensions.com roundtable November 2007 37

on an annual basis, which is a 3% alpha per year over the global managers. Over three years, there were similar conclu- How best to access sions. The index returned 31% per annum, the global managers returned 33.6%, and the portfolio of the regional specialists produced 34.4%. So looking at these numbers, it seems that employing emerging market alpha a combination of regional specialists pays off. Wim van Iersel: Is it true that you can say that the outperformance of, let’s say the higher alpha of the regional funds, goes for every region in the world? Meaning that there’s an outperformance of on average three percentage points versus the global markets in Asia, in Latin America and emerging Europe? Is it the case across the regions or is it the case in general?

Alberto Miazzi: It depends also on the way you weight the portfolio in the different regions. I would say they are quite uncorrelated. Some- times we have a lot of alpha coming from Asia, the following year we might have a lot of alpha coming from emerging Europe, and another year we have a lot of alpha coming from Latin America. So on average, you’re right, it makes sense to say that it comes from everywhere.

Kristian Nammack: I was at a hedge fund conference recently and they were talking about the recent few months in the investment world Global Pensions gathered key industry experts in Amsterdam to discuss alpha generation in emerging generally, and someone made a comment about emerging markets and investment into commod- markets, pension fund appetite for the asset class, and issues of capacity and manager selection ities, and the way that institutions invest. A few years ago, a pension fund might have wanted commodity exposure and perhaps fol- Alex Beveridge: To kick off today’s debate Alberto duced over the period. As for the Middle East lowed the Goldman Sachs index, buying com- from Nomura will present some research from and Africa, they didn’t manage to gather a lot of modities indiscriminately. There was a larger Mercer Oliver Wyman, commissioned by information on those funds, as there were very correlation among the performance of different Nomura, on emerging market alpha generation. few specialists investing in the Middle East commodities because of this index approach, but and Africa, and since it is quite a small part of that’s starting to decouple. Alberto Miazzi: This analysis was to assess the MSCI emerging market index, the weight of Commodity performance in August showed whether, from an alpha generation perspective, it these managers in the overall portfolio is quite wheat was up, while other commodities were is better in the emerging markets space to opt for small. So instead of using this data, Mercer down. They made the same comment about the a global emerging markets manager or a com- Oliver Wyman used the index return from that performance for different emerging markets. bination of regional specialists. Effectively, do particular region. Five or six years ago, a lot of fund flow would the regional specialists add value over the best go indiscriminately into increasing emerging global managers? Alex Beveridge: What is the weighting to South market exposure, whereas today it’s more dis- To analyse this, Mercer Oliver Wyman exam- Africa in the index? criminate, region by region, country by country, ined a raw universe of some 1,000 funds, mostly so you’re seeing a further decoupling of the per- global and some regional. They then excluded Alberto Miazzi: It is about 8%. It is also worth formance based on fund flows only. funds that weren’t live for more than three years, mentioning that this is an example over three and narrowed down the analysis to exclude those years. Later on we will look at the five-year anal- Alex Beveridge: After hearing that evidence, funds that were non-equity focused. Another ysis, but bear in mind that it’s not exactly the should pension funds look for region-specific man- screen was applied to the new universe of 633 same sample, it depends on how the underlying agers or can some managers truly call themselves funds to eliminate funds which were duplicated managers performed during the period. global experts? Wim, which do you look for? due to listings of different share classes. The final sample comprised about 450 funds, with Anton Kramer: How do you do that then in Asia, Wim van Iersel: Regarding our emerging mar- about half consisting of the regional special- where you have a lot of Pacific funds that also kets portfolio, we’ve got three global managers ists, meaning Asia Pacific, Latin America and include some developed countries? in place. Looking at the performance numbers Emerging Europe. since inception, and some of them go back ten There was a small issue with South Africa and Alberto Miazzi: In this analysis, the Asia funds years, they all achieved outperformance. With I will briefly touch on this later. These 450 funds did include some wider Asia Pacific ex Japan regard to emerging markets, the first approach cover about US$200bn of assets under manage- funds, as well as dedicated emerging Asia man- was to look at them from a global point of view. ment and should thus be very representative of the aged funds, but the analysis shows this acted to We do think it’s interesting to have a closer look main players that are investing in the emerging reduce the alpha generation, so we don’t think it if it makes sense to select managers that have a market space. As for the methodology, with the distorts the results. regional focus. It is our fiduciairy duty. global managers it was fairly straightforward The regional specialist portfolios were put to identify the top quartile over three years and together in this way and they tried to draw some Anton Kramer: I agree, because although this hence identify the average return of this group. conclusions to assess whether the specialist study shows that in general it’s worth looking at To get a comparable number for the combina- approach adds value over a global emerging the regional specialist; that still does not mean tion of the regionals, what Mercer Oliver Wyman markets approach. The analysis over five years that there are no good global managers in the did was weight the performance of the top quar- revealed that on average the combination of the universe. It’s a matter of picking the right man- tile regional managers in each region [according regional specialists produced a return of 25% a ager and the way we’ve done it in our emerging to] the MSCI weightings. The way they did that year. markets pool is to have both, so we have regional was, using this three year example, to sort the Looking at what the index returned during managers looking at Latin America, Asia and performance of all the specialists over three years that period, the MSCI EM index return EMEA, and we also have two global In association with and then take the top quartile over this period. was 27% per year over five years. If you emerging markets managers. Using the same sample, they started from compare these with the average top quar- year one and gave them MSCI weightings, tile global emerging markets managers, Mark Roxburgh: One of the reasons that extrapolated the data to the end of the year and they got a return of 30.4%, which is about we were interested in commissioning that then re-weighted back to MSCI weightings. By 3% alpha over the benchmark per annum. research was that I came back from a trip to doing this they were able to create a synthetic But looking at the average top quartile per- the US where a large US consultant had told portfolio return to represent what a combination formance of the combination of the regional me that of the 25 emerging market man- of the best regional managers would have pro- specialists, they achieved a return of 33.5% agers they’d used over the last five years, 20 38 November 2007 roundtable www.globalpensions.com

agers who differ in style, but when it comes to global emerging markets and you’re buying a few global managers, do you actively look for a growth manager, a value manager, a large cap, a small cap, a trend, a quant? Also, has the asset management industry evolved enough in that space to have these different styles? I’ve heard it said that the emerging markets, by their definition, are growth-biased. That’s the top down idea behind emerging markets, they have a higher economic growth rate than developed growth rates, and perhaps the companies are also growth-like companies so you should have a growth bias.

Joseph Mariathasan: Well that then gives you the opportunity to go for Asian income funds or something like that, because the best Asian companies are now realising it actually pays to pay dividends, so there’s something to be said for going for value companies.

Wim van Iersel: Looking at the three managers we have in place, we indeed have a quant manager, a growth style manager and a player looking not only at stock-specific components, but also at macro themes. Three different styles, three different processes and they are all coming up with decent results.

Alex Beveridge: Was that a conscious decision when you were building the portfolio? had closed to new business on capacity grounds. Mercer Mercer Oliver Wyman research touched That made me think; if there is an issue for on, because we were keen to find out where the Wim van Iersel: Yes, indeed it was. people who want to invest in global emerging alpha was being generated, and they said that market mandates and good quality managers, of based on their research, some 20% to 30% of the Joseph Mariathasan: What concerns me slightly, which lots are clearly not available for business, total alpha would come from the region alloca- when you say they’ve all done well, is you’re what is the alternative? tion decision. comparing them against an index. To my mind Is the regional combination an opportunity for So the majority didn’t and we thought; if the indices themselves are rather artificial con- people who haven’t invested but do want to get you’ve got good regional managers who are structs and if you look at MSCI, 50% of it is con- into emerging markets? going lower down the market cap spectrum centrated in about four countries. and they have potential to generate more alpha As soon as you compare yourself with an Joseph Mariathasan: I’ve heard the same from because it’s a more inefficient market, then that index, you’re assuming the index has some real people like Russell as well. One of the big distinc- should make up for the fact they’re not doing any value, and I would argue most emerging market tions they make in emerging markets is between regional allocation, so that was the trade-off we indices are no value at all, because they have those managers that are closed to new business saw as having great potential. absolutely no relationship to your liabilities, they and those that are open, because historically have no relationship to any economic theory everyone has been going for global emerging Alex Beveridge: What characteristics do you look and they are really just a collection of countries markets managers. for in your managers? that are put together in terms of some arbitrary The fact is that most of the decent ones are market weighting factor. closed to new business or, if they’re not, they Mark Roxburgh: When we were putting the should be, because they obviously need some strategy together, we weren’t looking for any Wim van Iersel: It’s true, but that’s also the case sort of capacity constraints to be successful. particular style, we simply said we wanted for developed markets. something that works in the region, because if Erik van Dijk: To some extent I agree with what you ask a global manager whether they apply Joseph Mariathasan: Yes, but the problem is Anton said, you need to look at them as two sep- their investment philosophy globally they’ll say For more on people are comparing their own portfolio with arate pools. The regional top players are basi- yes, but you tend to find they’ll adapt it to what emerging markets an index as the minimum risk position, or they’re cally those that go for a concentrated approach, works on a regional basis. visit our website: comparing alpha against that. I agree you could they really know how to pick the right stocks in So we were looking for people who had a argue the same thing with developed markets, globalpensions.com a specific market, so bottom up components are proven investment philosophy and process that but in actual fact the US market is a different more important. had worked over time and was consistent. We case, it’s one marketplace in many senses. Whereas the global top players are playing weren’t looking for any correlation with other If you look at emerging markets, you’ve got a game with sensitivities to specific factors managers in the different regions. indices where 50% is in four countries, and yet that work in a specific region. I would say that there’re another 40 countries to invest in, so I in the end you should always have a mix, so in Joseph Mariathasan: What do you think is a would argue that people need to move away that respect I like the multi-manager approach, capacity constraint for your strategy Mark? completely from that sort of index mentality and because for the average pension client the alloca- start afresh. tion is still too small to go for four or five man- Mark Roxburgh: Alberto’s just finished a fairly agers to capture emerging markets. long exercise actually where we’ve asked each Wim van Iersel: I agree. When you select man- of the managers to do some detailed work and agers it depends on whether you want to be Joseph Mariathasan: Maybe it’s worthwhile also we’ve looked at the liquidity on the portfolios, benchmark-driven or benchmark-aware. Bench- mentioning here the other extreme, which is to and have come up with a figure of US$5.5bn for mark-driven for active management is, in many go passive. If you look at a firm like Dimensional the total emerging market exposure across the cases in developed and emerging markets, not Fund Advisors, they’ve got a global emerging three managers. the way to act. Being benchmark-aware means markets fund with 1,500 stocks in it, and in their We think that’s realistic but it also gives us a you take the benchmark into account. value portfolio they just buy the top 30% of point at which we can say, ‘We’re approaching stocks that are cheapest. that figure, we’ve got to think about closing Alex Beveridge: Anton, how do you con- the strategy.’ In association with struct your managers? Have you got dif- Anton Kramer: A point that relates to this question ferent styles? is if you think you can add value by over/under- Kristian Nammack: Someone mentioned weighting the complete region because that can having a multi-manager approach on a Anton Kramer: Yes, we have three regional be an advantage of a global emerging markets global basis as opposed to regional spe- managers, all three are mostly bottom-up manager. cialists. stock-pickers, although two of the three The idea in my mind behind a multi- regional managers also have a top-down Mark Roxburgh: That was something that the manager approach is that you pick man- view. These three managers of course have www.globalpensions.com roundtable November 2007 39

their own process for selecting stocks. should always do that because you can diver- Alex is the editor of Global Pensions. Prior to joining For the two global emerging markets man- sify your risk and take up other opportunities in the magazine, he was a news and website editor for agers we definitely look at whether they fit your portfolio. Charterhouse Communications, where he covered together. One is more of a bottom-up investor the UK mortgage market. Alex has a degree in politics with a large diversified portfolio and the other Kristian Nammack: I haven’t heard the term BRIC and communications studies from the University of one is a concentrated stock-picker, which does used in a while. I’ve seen a frustrated attempt at Liverpool and a post graduate diploma in journalism not pay a lot of attention to country or bench- investing in single-country products, especially from the Journalism Training Center in London. mark weights. They use a very different style China and India. I know of one large institutional and their portfolio holdings are very different. investor that had a bad experience in that he was Alex Beveridge convinced that China was the future, as many Anton is a portfolio manager at TKP. TKP is a100% Kristian Nammack: Certainly what I’ve seen in of us were, or even are, and bought a China-only subsidiary of AEGON, a fiduciary manager for pension this product from Nomura is that obviously fund and suffered its volatility, and it scared that funds. Clients include the pension funds of KPN and TNT. since you rebalance back to the regional index pension fund off a lot of emerging markets. AuM stands at €10bn, invested using a multi-manager weights once a year, there’s no betting on the approach. Anton started working for TKP in 2000. He is three regions. Joseph Mariathasan: I’m absolutely amazed. responsible for manager selection in Asia and emerging Within each region the managers do diverge I launched a China fund ten years ago and it’s markets. He graduated in economics from the University from the country weights if they want to, but done incredibly well. of Groningen. He is a CFA charter holder. performance is primarily driven by stock selec- Anton Kramer tion. The volatility of countries is enormous, it’s Kristian Nammack: Presumably it did see some Joseph is an independent consultant and investment unforecastable risk – it is often political, weather volatility? specialist. He has a close association with StratCom, risk and event risk, so my bias has always been a research-based strategy consultancy focussed on managers who do stock selection as their pri- Joseph Mariathasan: Yes, we did see some vola- financial services, and is also a consultant and advisor mary way of producing return. tility. to Vermilion Partners. Joseph has worked for Shell International, Kleinwort Benson, Aviva (Morley Fund Alex Beveridge: I am interested in the BRIC phe- Kristian Nammack: BRIC as a concept is well Management), and GMO, in a variety of technical and nomenon. Some people have suggested that per- understood by a lot of people, but I’ve seen people senior management and business development roles. haps the concept is a bit tired and we should be go either one way or the other. Joseph Mariathasan looking beyond this BRIC horizon. What’s your Alberto is the product specialist for the Nomura Global view Joseph? Mark Roxburgh: As Anton and Wim pointed out, Emerging Market equity strategy. Alberto is primarily why restrict yourself when there are 30-odd responsible for analysing Global Emerging Markets at Joseph Mariathasan: Some people have come countries that you can potentially invest in that Nomura Asset Management UK and was previously out with another concept called CEMENT, can give you good alpha opportunities? involved in research of European fund managers at Countries in Emerging Markets Excluded by Watson Wyatt. New Terminology, which is essentially all the Alex Beveridge: So what other countries should emerging markets except the BRIC countries, our readers be looking at? the argument being of course, that you need Alberto Miazzi both CEMENT and BRICs to have a solid port- Joseph Mariathasan: You have the middle ranking Kristian is the director of Polaris Consultants LLC, a folio. BRIC is a great marketing concept and has countries in emerging markets, but you also have consulting firm focusing on giving strategic advice some important dynamics in terms of analysis; the frontier markets, and what’s interesting now to pension funds, family offices, and other investors. the danger is when people try to turn it into a is that some firms and managers are looking at Polaris also occasionally advises asset management product. frontier markets. Arcadian in the US is offering firms on strategic issues. Prior to this, he was head There’s no doubt that those four countries are frontier funds, and an emerging market fund- of the Alpha Team at Skandia Liv Asset Management going to become incredibly important going for- of-fund manager called Old Square Capital is in Stockholm, where he worked with investing their ward. Of the four, I suspect Chindia – China and looking at countries like Botswana, Bangladesh E30bn portfolio. India – is probably more important than Russia and so on. Kristian Nammack and Brazil, for all sorts of reasons and, arguably, That’s really where emerging markets were Mark heads up both the business development if you were going to take that concept you’d be 15 years ago, so do you want to be in those? I and client service operations of Nomura Asset better off just looking at China and India rather suspect people may want to have a very small Management UK (NAM UK). He has been with NAM than including Brazil and Russia, because then allocation to those sort of markets. Old Square UK since 1999. Prior to this, Mark held a number of you have to include Mexico and maybe a couple Capital itself tries to find the best country and senior client relationship and business development of other countries. regional managers available to tap into the roles at Morley Fund Management. whole universe of emerging markets, not just the Erik van Dijk: I think it is here to stay. Looking at frontier markets. the portfolio concept, the overall portfolio in the Mark Roxburgh region is still relatively small, it will be around Alex Beveridge: Anton, from a pension fund point Erik is CIO and partner at Compendeon Pension and 5% to 10% maximum, and I don’t think it’s a of view, do frontier markets scare you or are you Investment Management in Bunnik, the Netherlands. bad concept, especially for smaller and mid-size considering them? Before this he worked in the US on Asset Allocation plans. Joseph, you’re right, China and India are Systems and in the Netherlands for Palladyne Asset probably in the long term more important, but I Anton Kramer: We do not restrict our managers Management as CEO and partner, in addition to Fortis don’t find it to be a bad marketing concept. to investing only in the countries that are part Investments as head of quantitative strategies. Erik has of the MSCI universe, so for example our man- also written a book on quantitative investments and Alex Beveridge: Wim, as a pension fund, are you ager in EMEA is, within Africa, not restricted to supplied articles for magazines and journals. invested only in the BRIC countries or is the allo- only investing in South Africa, but also has the Erik van Dijk cation much broader? ability to invest in countries in Central Africa as Wim is currently responsible for fiduciary asset well. It is obviously much more difficult to get a management at SPF beheer. He started at SPF beheer Wim van Iersel: We’ve invested almost 20% of our meaningful exposure in these markets though. ten years ago. His responsibilities include selecting equity portfolio in emerging markets. We found and monitoring external managers for fixed income, that looking at emerging markets in general Joseph Mariathasan: The problem is a lot of these equities and alternative products on behalf of current there was more to be gained in terms of perform- markets are so small that when you get a large clients. Solutions are also provided for potential clients. ance. amount of foreign cash going in, it will just wind That was the reason for us to step into a larger the market up, and when they pull it out they allocation to emerging markets. Second, if you wind the market down again. Wim van Iersel look at the BRIC countries’ performance num- It’s probably fine for small amounts, but bers, it’s been a wonderful theme and not only capacity is just so low that I’m not too sure it’s from a marketing perspective, but the question going to be a significant proportion of any insti- is, of course, is it here to stay? If you look at what tutional investor fund. the Russian government is doing with raw materials, In association with Kristian Nammack: I have a there might be some cracks in question for Wim. The Dutch this theme. are among the leaders of socially responsible investing, Anton Kramer: If you have the demanding high levels of possibility to invest in other corporate governance and countries aside from these so on, and when it comes to four, then as an investor you emerging markets certainly 40 November 2007 roundtable www.globalpensions.com

things are getting better, but when it comes to receptive to the idea of an allocation to emerging was 13% of the FTSE 100 index. So a typical UK frontier markets, does your pension fund have markets? pension fund would have 5% of its total fund in an SRI policy? And how does that impact your Vodafone, more than they had in the whole of the investments in emerging markets? Mark Roxburgh: In the US, definitely, they’re emerging markets, and they all think that they much more aware of the alpha opportunity in weren’t taking risk. Wim van Iersel: The policy is currently under emerging markets. A survey published earlier in investigation. On corporate governance we ask the year looked at the global equity ex-US man- Erik van Dijk: I’d like to use a metaphor from one of our managers to vote on every company they agers, in terms of where the alpha was coming my pastime activities, chess. I’m a member of the hold in their portfolio. Meaning we have an from on such mandates, and by and large it was board of the Dutch Chess Federation. If we, as an active voting policy. coming from their emerging markets exposure. experiment, played a tournament of chess and Across Europe emerging markets are still we were all amateurs, then probably on average Alex Beveridge: Anton, is SRI a consideration for quite popular. Some of the large consultants all of us would produce an average result, which you? have identified it as a return-enhancing asset, is efficiency, with some volatility, because some- so we’re seeing more recommendations from big times you’re lucky and sometimes you’re not. Anton Kramer: Yes, and I think it is for every Now, if somebody had knowledge or informa- Dutch institutional investor these days. We do tion, then the likelihood of us producing the same a screening of the holdings in our portfolio each “BRIC is a great marketing concept and result reduces. So if in chess one person can be year using an external adviser and we then make has some important dynamics in terms of better than the others, why can’t an asset man- a list of stocks that are excluded from where our ager? The likelihood of that happening is larger investment managers can invest in. analysis; the danger is when people try to the less information there is about the market, so turn it into a product. There’s no doubt that the inefficiencies in the emerging markets make Alex Beveridge: Eric, is this a question that comes those four countries are going to become it more likely that the real alpha generators are up a lot? in that type of market. I agree with Joseph that incredibly important going forward” because emerging markets are still so inefficient Erik van Dijk: Yes, definitely, and more now espe- Joseph Mariathasan you should incorporate them in any portfolio. cially in the emerging markets than elsewhere. My experience is that at the moment it’s mainly Alex Beveridge: Anton, do you think there is a concern on a company level rather than a consultancy firms to include emerging market greater interest now in emerging markets than country level. exposure in global equity mandates or indeed in the past? as standalone mandates so yes, there does seem Alex Beveridge: Mark, from an asset manager’s to be more institutional appetite for it going for- Anton Kramer: Yes, simply because the returns point of view, is this something you’ve come up ward. have been great in the last five years. For our against? clients, we’ve been investing in emerging mar- Joseph Mariathasan: People have become over- kets almost since we started in 1989. Most of our Mark Roxburgh: Yes, we’ve seen it on a number of awed by the whole idea of efficient markets; clients made additional allocations to emerging searches where there’s an external SRI adviser Harry Markowitz, the founder of Modern Port- markets a couple of years ago, so in that sense providing some form of screening. Particularly folio Theory, which was extended to incorporate there was more interest in investing in emerging in the US market, it’s very popular for some of the idea of efficient markets by Eugene Fama, markets, for the same reasons we’ve been dis- the big pension funds over there to literally have certainly does not believe in efficient markets cussing earlier, the higher expected returns. no exposure to a particular country, which cre- and has spent part of his career trying to find ates challenges for the manager, but is just part ways of beating the market. Over many years Alex Beveridge: Something that always comes up of the way the world is these days. As long as the people have taught in business schools that mar- when you talk to pension funds about emerging manager isn’t too restricted, it’s not a particu- kets are efficient, and therefore if you invest in markets is whether there is more or less political larly big issue. equities your lowest-risk allocation should be the risk involved in investing in emerging markets market capitalisation portfolio, which is about today. Anton Kramer: The corporate governance issue 50% US. is not only related to emerging markets though, If you throw away the whole idea of market Erik van Dijk: Obviously it’s a lowly correlated because there have been scandals in the devel- efficiency, you’re not going to put 50% in the US group of countries and you need to be aware of oped markets as well. because it’s the market cap, you’d be thinking, what happens locally. Then again it’s a little bit ‘What are the growth prospects of each market- less than it was ten years ago, with the Asian Alex Beveridge: Has the recent volatility in global place and what are the risks?’ and you would and Russian crises, simply because, as a result markets led to a reassessment of global emerging allocate that way. of them now being more focused on international market allocations? Pension funds as a whole are being sold this trade, they’re in a way more tied into the world market efficiency idea, and as a result they’re community. Kristian Nammack: A number of people I speak hooked on the market cap portfolio as the one But my metaphor when using the chess world to are putting on hold any major decisions, but that they should be basing their decisions on. is a good example; I wouldn’t dare to invest in they’re also looking for potential opportunities. That means emerging markets have always got Russia without knowing the managers that I If you believe that part of what happened this a much lower percentage than they should have. know and my friends from the Russian Chess summer was just a liquidity crunch that created I’m delighted to hear you have a 20% allocation, Federation who are often political insiders. indiscriminate selling of assets to raise cash to Wim, because that implies that you don’t have Without those two relatively uncorrelated pay margin calls, then obviously it creates some that philosophy. sources of information I would consider myself opportunities. to be too uninformed when it comes to political Where the dust settles and where you will find Wim van Iersel: I completely agree with you. In risk factors. the bargains is yet to be determined, but I have the early 90s, Japan had a 40% weighting in specifically heard people talking about emerging the MSCI. There was no reason for us to have Joseph Mariathasan: Even in mainland China markets as being one place where the fundamen- a 40% weighting in Japan, and right now that’s I’m always fascinated by the fact that the rule tals have not changed. the case for the US too. What we try to do is find of law is becoming much more important to eve- out where performance can be made for the long ryone and you don’t get the political interference Wim van Iersel: We increased our weighting in run. in companies that you’re seeing in Russia, so I emerging market debt and equities as a result of would make a huge distinction. the global credit crunch. Kristian Nammack: I’m also seeing quite a lot of pension funds specifically talk about de-risking Wim van Iersel: If you look at the world you see Mark Roxburgh: Emerging markets seem to have their portfolio, so moving a large chunk of assets other risks evolving, meaning that there is a held up very well compared to developed mar- into index-linked bonds and other securities. transfer of economic, political and military kets, and if you look at the fundamentals, they’re Then whatever bit they want to play with moves power to emerging markets. probably in a much better position than they’ve to much higher risk assets with the expectation The balance of power shifts. This means ever been in terms of being able to ride out of higher return, and there people talk that we will encounter additional risks between In association with the volatility. They’re up about 18% in US more about emerging markets. regions going forward. dollar terms this year, so it’s still a very good result if you’re taking a long term Joseph Mariathasan: This whole idea of Anton Kramer: The managers we hire are obvi- view, which obviously pension funds will risk is fascinating, because if you look at ously paying attention to it, but it’s more their be. what happened in the late 90s, a typical decision to invest in certain countries or to not UK pension fund would have had 70% of invest in certain countries. It’s true that most of Alex Beveridge: Over the last four or five it assets in equities, half of it would have the emerging markets do not have much debt years, have pension funds become more been in UK equities, and of that Vodafone anymore, unlike ten years ago, so they are more www.globalpensions.com roundtable November 2007 41

time further down the road compared with the global emerging market managers.

Mark Roxburgh: What you’ve got to be wary of is that the average global manager underperformed the benchmark by nearly 2%. The average global emerging market manager is not someone that you’d want to select.

Alex Beveridge: Wim, you’ve got a big allocation to emerging markets, have you had to wait to invest some of that money to get the manager you wanted?

Wim van Iersel: No, it took a long time to select them, about six months or so, but the opportunity arose and we were fine with the manager in place. We were able to allocate the money very quickly. But we didn’t say, ‘You have to be invested tomorrow.’

Alex Beveridge: Anton, have you come up against capacity issues?

Anton Kramer: It’s something that we always look at when we’re selecting managers and especially when we conducted the search for global emerging markets managers. Apart from diversification, that was another reason why we selected more than one manager, we now have more flexibility in case of inflows in our Emerging Markets fund. self-sustaining, but on the other hand, like we markets. saw in Thailand, there still is political risk. Alex Beveridge: I just wanted to touch on the issue Joseph Mariathasan: Again this comes back of correlation. How closely correlated are the Alex Beveridge: Mark, does this play to what to the global versus regional. I’d be wary of a emerging markets today, as it certainly used to you’re doing here as a specialist? global manager that launched a mid cap or small be the case that if one struggled then the others cap fund, because I’d be wondering how they would struggle too? Mark Roxburgh: All the managers have a polit- do the research in that depth and whether they ical filter at their final decision-making stage. are all going to be picking the same stocks? It’s Joseph Mariathasan: It’s interesting looking at They may like some great stocks in some lovely a bit like the problems we had in the quant funds emerging market debt, where the 1997 Russian countries, but when they add the political ele- where over the summer all the quant funds were crisis sent shock waves throughout the whole ment, they may not be able to invest there at all. using similar processes and found they were all debt market, yet since then there have been a So I agree with the consensus, there is less shorting the same stock. So the danger is that number of mini crises which had nowhere near political risk than there was certainly five or you end up going for certain types of managers the same effect, so there isn’t this knee-jerk reac- ten years ago. It’s still there, but we’re talking who are using similar processes, who are essen- tion now. about quite a broad basket of countries, so tially buying the same stocks and then may try If something dramatic happens in Argentina, diversification should be able to reduce that to get out at the same time. people don’t go and sell Turkey, which was the quite a bit. case in the past. So clearly correlations have Kristian Nammack: It’s also hard to know how gone down at the country level. I suspect at the Kristian Nammack: I’d echo that final comment. much performance in less liquid asset classes stock level there’s probably much higher corre- At the end of the day, the way most of the people comes from fund flows versus changes in fun- lations with the global sectors than there used I speak to mitigate political risk is to invest in damental opinions, and if we all start agreeing to be. emerging markets globally, whether that’s that global emerging markets are a worthy asset through regional managers or global managers, class and we all start to allocate 20% instead of Kristian Nammack: I agree. The anecdotal evi- but not to make big bets in any one country. 5%, and you see huge fund flows into this area, dence is that different countries are a lot less it could artificially boost the return on some of correlated as opposed to being a block of Alex Beveridge: If we turn our attention to these stocks. emerging markets. What I’d like to study is liquidity, Joseph, you mentioned you were fairly whether there are sub-regional correlations comfortable with the liquidity in many of the Mark Roxburgh: The figures I saw most recently among countries based on what drives their markets now. suggested still strong positive flows into economy. There are probably correlations emerging markets this year and quite a signifi- within regions, but certainly it’s breaking down Joseph Mariathasan: Yes, apart from the frontier cant outflow in US equities from international on a global basis. markets where there are big issues. If you’re a investors. So there is quite a lot of money moving 20- or 30-year pension fund, illiquidity should be into emerging markets. Erik van Dijk: Professor Bruno Solnik, who is now your friend not your enemy, because you should in France at HEC School of Management and in be able to take an illiquidity premium, so you’re Kristian Nammack: It also brings up the issue the past was at MIT, has done a lot of research crazy looking for liquid markets, you’re better off about capacity in global emerging market man- on correlations, and Joseph is right about the looking for illiquid markets and benefiting from agers, as Mark mentioned earlier. Many good stock level versus the country level, but the other investors who can’t afford to take that sort managers are closed to new assets, and that’s an tricky thing with country levels is that when of a time horizon. issue for investors, especially very large inves- things are going well in a country, or the world, tors or public pension funds of certain countries or the combination of both, people tend to care Kristian Nammack: I completely agree. and certain states in the US. less about what’s going on elsewhere. But the moment something bad happens, they will then Wim van Iersel: I also agree. Alex Beveridge: Do people settle then for second concentrate on what effect it will have on their tier managers? portfolio and the markets with the large betas, Mark Roxburgh: That’s the advan- which are still the emerging markets, will be In association with tage of a long term view. Joseph Mariathasan: Most of us would probably the first ones to be beaten up. agree that you don’t have to settle for second tier In the last three or four years, these markets Anton Kramer: The only thing you global managers if you can get first tier regional have done tremendously, so in a way the real should avoid is the investment and country managers. test is; is this a new world with truly increased managers that create their own global correlations for emerging markets, or is it market, that might happen in fron- Anton Kramer: Yes, but on the other hand if the just a phase that we’re in? A bad period of two or tier markets but also in the mid first tier regional manager is successful then you three years in a row is what we need in order to and small cap areas in emerging also end up with capacity issues, possibly some find the answer.

emerging markets – special report

n September Greenwich imise the regional specialties of each firm. The Associates released a report Nomura vehicle was the first time that Merseyside revealing that institutional had gone out on its own with an allocation to I investors had been “moving into emerging markets. international equities at a rapid and consistent Alpha spurs Mark Roxburgh, executive officer, head of rate for the past 24 months.” It said US institu- marketing and client services at Nomura tions had doubled their Latin American holdings Asset Management, explained how the GEM to over US$20bn between 2005 and Q1 2006. product came into being. “We had a belief that While Greenwich’s study reported less frenetic a combination of three specialist regional man- movement from European pension funds, it did on emerging agers would, when combined and managed with find that many expressed an intention to increase some overall investment controls and constraints, international equities. provide some very good opportunities in the The two reasons given for this shift were the emerging market space.” growth in demand for alpha and a desire for diver- He said Nomura accepted that it did not have sification. These twin desires of pension funds the skill set in-house to do the EMEA or the Latin are of course nothing new and account for the markets American block. general growth in interest in alternative invest- Realising it had the majority of the asset base – ments. However, it is becoming increasingly clear around 50% of emerging market stocks are Asian that emerging market managers are latching on to – Nomura decided to hire two external firms who the needs of pension funds and are promoting were proven in their particular area. The idea themselves as the natural providers of these much was to combine the managers’ track records to sought after investment goals. see what they looked like. As John Colon, consultant at Greenwich point- Charlemagne Capital was appointed for the ed out:“International equities, with their superior EMEA sector, and Gartmore won the Latin performance over the past several years and their American brief. A study was then carried out relatively low level of correlation to domestic by Mercer Oliver Wyman to review the equities and fixed income, appear to fit the bill on statistical case as to why three regional managers both counts.” would produce performance to rival global Given the long term liabilities of most pension managers. funds, an allocation to emerging markets would The Mercer study showed the new hybrid prod- seem prudent. These markets have the most uct competed with the best first quartile global potential for growth and given that many are fast equity managers. developing into fully fledged developed economies “One of the things the consultants were telling it could be argued that it would be risky not to at us was that if you look at the last couple of years least have some exposure to them. most global emerging market managers were However as the recent military coup in Thailand really good at one region, average in a second, has demonstrated, things can change very fast but they were weak in the third.This was because in these countries. Political risk, liquidity, and trying to stretch competence over 27 emerging corporate governance are all areas of concern As pension funds seek to globalise their portfolios, emerging markets is really too much for most people,” when looking to invest in emerging markets.While explained Roxburgh. some analysts see events such as the Thai coup as markets are forming an increasingly large part of their asset The other key part of the Nomura hybrid is that a buying opportunity, it is understandable if some it does not take any regional bets in terms of allo- pension fund members are spooked by such allocation. Alex Beveridge reports on how this sector is cation. Roxburgh said:“Most of the alpha is gener- occurrences. seeking to meet the needs of pension funds ated at the stock and sector level, which led us to Another key concern which has been raised by decide to be neutral to the regions, only rebalanc- consultants in the field is that of capacity con- ing if they get more than 3% out of alignment with straint.With a rise in popularity in the asset class investments, as the country prepares itself to host ing market equities for Russell Investment Group, the benchmark weighting.” there is the temptation for good managers to take the 2010 World Cup Football tournament. commented: “In our view you can be successful Merseyside’s Otter said while the bottom- on too many assets. Also, some investors, feeling Meanwhile, some of the bottom-up stock pickers using a variety of different methods, either up/top-down debate was interesting, “we tend to left out of what appears to be a lucrative sector, have been badly mauled. bottom-up, top-down or something in between.” go for good stock pickers, irrespective of their could compromise on the quality of managers Bottom-up practitioners, meanwhile, believe style.” simply to gain access to the market. there is a value in taking a long-term view of a He added:“These things have runs, but I guess if There is also the matter of what is known as company. They argue that a company which is The Merseyside experience you look at the very long term then it tends to the frontier states.These are countries which are, well embedded in a local economy is better placed One UK pension fund which has recently made a revert to the mean. So, ultimately the name of the as yet, not on the map for most emerging market to withstand cyclical shocks or sudden shifts in significant (around 2%) allocation to emerging game is picking good stock, no matter what you investors but which could form an important part currency valuations. markets is the Merseyside Pension Fund. follow.” of a portfolio in the future. Some consultants argue that from the viewpoint “We have been involved in emerging markets He said there had been a move to diversify First Sate Investments recently flagged up of a pension fund it could be better to be diversi- for a while, but we used to do it via pooled vehi- because of the concentration of the UK stock Vietnam, Kazakhstan, Botswana and Zambia as fied across a number of different strategies and cles,” explained Leyland Otter, senior investment market: “You can be investing in a highly concen- frontier states. global sectors, in much the same way investors manager at the fund. trated portfolio if you are tracking the FTSE100. According to David Gait, senior portfolio man- seek safety when investing in private equity or The fund invested in the Nomura GEM product, For example you are heavily into oil stocks, which ager for Asia Pacific (ex-Japan) at First State hedge funds by gaining access via a fund of funds. which bundles together the expertise of three is not great from portfolio diversification point of Investments, pension funds should be aware that Scott Crawshaw, portfolio manager for emerg- emerging market managers in an attempt to max- view.” some of the so-called BRIC (Brazil, Russia, India According to many pension fund investment and China) countries, which have enjoyed huge Investment approach for emerging market portfolios professionals there is a belief that trustees are popularity with investors, were not even classed more comfortable with understanding an as emerging markets 10 years ago. emerging market portfolio than perhaps they While admitting that liquidity was a key chal- are with some hedge fund strategies. lenge in these countries, he said he believed that if “Diversifying your stocks and shares is an easy an investor was willing to allocate capital over a concept to understand, rather than some exotic three to five year period there were good oppor- hedge fund strategy,” said Otter. tunities to be had. Employing sector specialists is increasingly seen as the best way to benefit from emerging markets. As Wouter Pelser, director of asset management Stock picking and fundamentals at Dutch pension fund administration service MN A key debate which is opening up across the Services said: “We shifted from traditional man- emerging markets sector is that of bottom-up agers to boutiques. It’s about alpha, and that’s stock pickers versus a more macro economic top- about skilled people.” down approach to investing in these markets. This belief was mirrored by an AP1 spokes- Arguably the debate has been ignited by the woman, who said despite a recent performance recent success of the bottom-down practitioners slump,AP1 remained confident in active emerging who have seen their approach well rewarded of market equities. “We are moving to active man- late.The reason for this success is best typified by agement as we think it’s a market where you events in South Africa.There, those taking a macro Source: Greenwich Associates could create added value after costs if you are a approach have benefited from large infrastructure good manager,” she said. www.globalpensions.com october 2006 29

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or some people, emerging markets nesses did, in wasteful real estate investments as offer the best of all worlds – high they saw diminishing returns on capital in their growth, billions of people, low home markets.This may also be a time of curious- F costs and tons (or barrels) of ly large flows into offshore bank accounts. commodities. For others, they flatter to deceive: Emerging The situation now could not be more different: potentially undermined by changes in government, 2005 saw record surpluses, even if one removes cronyism and corruption and a corporate culture China’s massive near-$150bn surplus including that values image (sales) over profits. FDI. While these numbers will be lower this Of these two extreme opinions, which is the year, it is still encouraging to see a surplus in closest to reality? In our view, the former out- each region – Asia ex-China, EMEA (Europe weighs the latter view by some margin, although from the Middle East and Africa), Latin America and, of being aware of risk is one of the most important course, China. challenges facing a manager in this space. There is no doubt that, whatever corporate shenanigans occur at the likes of Enron and WorldCom, corporate malfeasance remains What exactly are greater in emerging than in developed markets. emerging markets? shadows Risk management is therefore critical in the asset Since the expression ‘emerging markets’ was first class. coined in 1981 by Antoine van Agtmael, then at This means knowing the regulatory and the World Bank, it has been used differently by dif- legal framework of the markets, being aware of ferent people. liquidity should you change your mind and know- We prefer to define emerging markets negative- ing which countries, sectors and stocks within the ly: ie. as those markets that are not developed. portfolio your risk is coming from. This includes countries represented in the MSCI This also means getting your hands dirty and Emerging Markets indexes as well as others which going out on the road – even if this has, in my case, have become investable. involved a terrifying helicopter ride through a pass We use this even though the phrase is some- on the Kyrgyz-Kazakh border and a failed coup in what misleading. The word ‘emerging’ implies Manila. But fund management is not merely anoth- progress, which tends to be very uneven. er form of adventure tourism. Believe it or not, Zimbabwe was considered by Experience counts. You have to ask the some an attractive proposition in the 1980s. This right questions of the companies you invest in, is surely a submerging market.Yugoslavia was once quarter after quarter, year after year, which is portrayed as an interesting ‘third way’ in Europe – why at Charlemagne Capital we have an experi- but its collapse with the fall of communism led to enced team which spends a lot of time on a peak-to-trough fall in Serbia’s GDP in the 1990s the road. of an astonishing 85%. Serbia has since recovered, but its per capita income is now on a par with Thailand rather than Assessing the market that of most of its neighbours. A qualitative assessment of the case for emerging Even the bigger emerging markets do not markets must be combined with a valuation analy- emerge in a straight line: recall the Asian crisis in sis. On this score, the message is currently mixed. 1997/8, or the tequila crisis in 1994, as well as That is, the bond market suggests that we are individual instances (Russia in 1998, Brazil in (almost) in the best of all possible positions, with 1999…). So countries emerge at different rates, EMBI spreads close to a record low. if at all. This indicates investor appetite to ‘risk’ is not The fundamental case for the asset class is very far from its peak.This in turn would point to high simple: it’s all around us. If you are reading this at valuations in their equity markets, especially at a work, look around your desk. Your phone, your time when the outlook for earnings growth is still PC, your mobile – all are either made, or assem- bright. UBS, for example, forecast 20.3% net bled in emerging economies. income growth for 2007, compared to 13.5% for To look at it more broadly, the developed developed markets. world accounts for a mere 16% of the world’s Emerging markets have evolved significantly over the past However, valuations as a whole remain modest. population. quarter century and while some still see them as a poison While there are, as ever, exceptions, the asset The rest live in emerging markets. If you look class in composite trades at only 10 times next at raw GDP data, these numbers are neatly chalice, Julian Mayo explains their attraction years’ earnings, compared to almost 13 times for reversed: the 16% account for 84% of the the maturer world. Furthermore, the valuation gap world’s income, while the 84% in emerging between emerging and developed markets economies generate only 16%. Should investors productivity rose 50% in the first five years of By contrast, Korea and Thailand are net remains firmly in the former’s favour. concentrate only on the substantial majority? the decade. importers to the tune of 5% of national income. Although the disparity has narrowed as a result Well, no. A cursory look at this year’s performance of the bull market over the last couple of years, On a purchasing power parity (PPP) basis, the demonstrated huge disparity in performance: as earnings growth has almost kept pace with market emerging market’s share rises to over 38%. So the Looking at asset diversification I write leaders include Peru (up 111% in local rises. asset class is too big to ignore. And yet on the Emerging markets also play an important role in currency), Russia (up 50%) and India (+30%), while For example, Brazil has been one of the world’s basis of market capitalisation, emerging markets asset diversification. Whereas for much of the laggards include Korea and Turkey, which are both best performing markets in recent years – but val- account for little more than one-twentieth. It’s 1990s the sector languished while developed mar- down on the year, and Israel which has barely uations remain low partly due to 59% earnings a case of paying six and getting 38, which is a kets (ex-Japan) boomed, over the last five years changed. growth last year. The consequence of all this is very attractive proposition. the sector has massively outperformed relatively Shares in Jordan have fallen 25%. These coun- that the asset class trades at a forward discount of The argument that the asset class is too big lacklustre US and European shares. Contrary to tries are driven as much by domestic as global some 20% to the MSCI World, whilst for much of to ignore is emphasised when one examines indi- some suggestions, more recent correlations considerations – which should be a relief for any the 1990s it traded at parity and sometimes even vidual countries. remain low. investor who believes that there is no longer such at a premium. It is widely known that China has for a while Over the last year the correlation between MSCI a thing as a non-correlated asset. The conclusion of this is that in my view invest- been the world’s second largest economy on a Emerging Markets and MSCI World has only been Despite this, there are broad cycles which need ing in emerging markets is not so much an option PPP basis, but less well-known is that it is now 0.21, while the former has a negative correlation analysing. One is the trade cycle.With the benefit as a necessity. more than twice as big as Japan, ranked third. with US Treasuries and corporate debt. The of hindsight, the crises in Latin America in 1994 It may sound hackneyed to say that indexing is India, currently fourth, is likely to overtake Japan sector is certainly not dependant on developed and in Asia three years later could have been fore- akin to driving with one’s eyes fixed on the rear in the next two years, while Russia’s commodity- markets as some suggest. It is also virtually inde- seen by investors looking at one variable only: the view mirror rather than on the road ahead. fuelled boom has propelled it into the global pendent of the global earnings cycle. sum of the current account and net foreign direct However, this is especially true when looking at top 10. The asset class also offers considerable diversi- investment (FDI). emerging markets which, as noted earlier, are Another misconception relates to labour: It fication between regions and countries.While the When the first swings into deficit, as it did in barely a fraction of global equity markets. Given is often thought that these countries add little Emerging Markets Bond Index (EMBI) spreads are both areas in the two years preceding the crises, the increasing scale of their economies and the value. However, productivity gains have been a good measure of overall risk in the sector, this shows a country living beyond its means and quality and valuations of their companies, this is impressive. Estimates by JP Morgan suggest economies vary considerably. Take commodities: increasingly uncompetitive exports. unlikely to remain the case for very much longer. that labour-cost adjusted productivity, ie. output Net oil exports account for almost 15% of A reversal of FDI flows suggests global business- per hour worked, adjusted for labour cost, in Russia’s GDP and close to 5% in the cases of es voting with their feet and keeping their money I Julian Mayo is an investment director at Poland is twice the EU average. In Turkey, labour Colombia and Malaysia. at home; and locals investing, as many Asian busi- Charlemagne Capital (UK) Limited 30 october 2006 www.globalpensions.com

emerging markets – special report

nvesting in emerging markets is MSCI (1999-2006) becoming the order of the day for MSCI MSCI many investment committees. Emerging Markets World I Some are attracted by the high 1999 66% 25% returns achieved by the asset class in recent Manager 2000 -31% -13% years, others by the long term prospects of devel- 2001 -2% -17% oping countries or the potential diversification 2002 -6% -20% benefits. Whatever the reason, asset flows into 2003 56% 34% emerging markets continue to rise as the asset 2004 26% 15% class heads into its fifth consecutive year of posi- selection in YTD 8/2005 31% 16% tive performance relative to developed markets. Source: Russell Successfully investing in emerging markets however is no walk in the park. After all, emerging emerging markets has improved recently; howev- markets are one of the most complex equity asset er, it is still difficult to draw conclusive evidence classes: liquidity is limited in many countries and from quantitative analysis of a manager’s portfolio corporate governance standards are not yet fully emerging alone. In many cases, the use of American developed.Trustees often face challenges opening Depository Receipts (ADRs) and Global the requisite custodial accounts that in turn allow Depository Receipts (GDRs) distort the picture. a full opportunity set to their money managers. Equally, while investors may have confidence in On top of that, the asset class is heavily capacity some variables (eg. country exposures or number constrained and some of the managers with the of stocks,) others (eg. I/B/E/S growth estimates) best historical performance are already closed to markets often need to be analysed with care. For that rea- new businesses. son, qualitative analysis is especially important in emerging markets. Qualitative analysis should focus on the invest- A crowded market ment philosophy, the quality of the investment Specialist emerging markets managers are not the team and the investment process.The investment only group benefiting from the good prospects of philosophy is often articulated in marketing mate- developing economies. Many international money rials but it is only after interviewing the manager managers offer opportunistic emerging markets face-to-face that investors can really determine investment as part of their global and Europe, the guiding principles behind each process. Australasia, Far East (EAFE) mandates. In many Interviews with management are also important cases, these managers do not charge additional to develop an informed opinion on the investment fees for including emerging markets exposure, team; while investors can often source CVs and effectively providing a cheap way of accessing the similar credentials from marketing materials, it asset class. As the chart below demonstrates, the is only after discussing the markets and stocks in emerging markets portion of EAFE managers’ the individual manager’s portfolio in person mandates has increased significantly over the last that we can gain conviction on them or identify decade. any behavioural biases existing in the investment team. Assessing the investment process is a key part Specialists or generalists? of qualitative analysis. First hand interaction with Russell Investment Group has conducted extensive managers helps unearth any anomalies between quantitative research on its manager universes to the ‘implemented’ process and the ‘stated’ process assess the advantages and disadvantages of utilising found in publicly available marketing materials. It is specialist money managers for emerging markets. Gustavo Galindo, explains how securing the right manager is the implemented process which needs to be well The conclusion from our research is that global suited to exploit some market inefficiency which and EAFE managers understandably tend to limit the key to emerging markets investing will be a source for excess return. their investments to the more liquid stocks with To help us do this, we at Russell have developed larger market capitalisations; as a result, portfolios GEM manager is selected, he or she will have the of about 90 institutional equity products around a set of manager research ‘best practices’ for cen- managed by specialists have provided better risk skill to identify country and regional risks and then the world. The second step is to determine tral elements of the investment process; these adjusted returns. In addition, large cap emerging suggest an optimal asset allocation. As a result, whether an investment product qualifies to best practices – coupled with a broad view of the markets stocks are more highly correlated with many investors have opted for GEM managers. become part of the universe.This is because there universe – help steer our evaluation. developed markets companies and, therefore, spe- are many managers that market themselves as cialist managers provide greater diversification global emerging markets managers; however upon benefits. Our research also suggests that specialist Starting the selection process closer inspection they lack investment coverage in No “model”approach emerging markets managers are better suited to A robust process for selecting managers relies on important regions. Other managers might be A thorough understanding of the market is vital in identify country risks which are still a significant three fundamental principles: knowing the oppor- excluded from the universe due to their use of order to conduct a proper analysis of any invest- factor to consider when investing in the asset class. tunity set, understanding the product and under- derivates, fixed income instruments, short posi- ment product. It is important to understand the Once the decision has been taken to use a spe- standing the market.This information is pivotal in tions or high cash balances. market inefficiencies available to investors. Equally, cialist money manager, the next decision is finding managers who implement a consistent some knowledge in capital markets and individual whether to use regional or global emerging mar- investment approach within stable organisations stocks is useful to assess the quality of investment kets (GEM) managers. The main disadvantage of and are therefore able to generate consistent, Know your manager professionals’ decisions. And of course, macro- hiring a set of regional managers is that the positive relative returns going forward. Potential investors then need to develop a deep economic factors will also impact manager return trustee would be faced with the challenge of The first step is to define a universe of man- understanding of the managers in the universe. It expectations. determining the appropriate regional allocation agers (the opportunity set); the Russell emerging is human nature to start with those that have gen- But there is no “model” or “right” approach for their portfolio. By contrast, if the appropriate markets universe for example tracks the returns erated the best returns. However, a quick look at when selecting investment managers – investors a manager’s marketing presentation can be useful will use different tools to examine different things, Emerging markets proportion of EAFE mandates to determine whether the people supporting the and certain areas of enquiry and research for one process are experienced and if they have a consis- manager will differ from those usefully applied to 70% tent investment approach – in short, the process- another. 60% es and people which increase likelihood of past Our experience is that different processes and return patterns being repeated in the future. It is style biases tend to be rewarded at different 50% also important to look for signs of commitment to times in the market cycle. If possible, it makes the product. This may be found in the big name sense to invest across a variety of styles, to 40% brands but equally in well-resourced emerging benefit from different market cycles and from market boutiques which may have a strong local investing with the best managers in their respec- 30% knowledge advantage.Together,these ‘fundamental tive fields. Intelligent combination of a variety of checks’ may prove to be an important comple- complementary styles harnesses each investment 20% ment to a pure focus in past performance. managers’ specific expertise, and leads to

E 10% more stable return patterns. So good night…and m good luck. e r g 0 Quantitative and qualitative i n I Gustavo Galindo is a research analyst, Emerging g 13/3/94 30/6/00 31/3/06 When analysing individual managers, quantitative Source: Russell m and qualitative tools are important. Data quality in Markets Equities, Russell Investment Group a r k e

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The material in these articles is provided for informational purposes only. Reliance should not be placed on the views and information expressed when making individual investment and/or strategic decisions.