Karen Gomm looks at the investment opportunities within BRIC countries and beyond, and how a multi-asset investment strategy may be the best approach for pension funds to invest in emerging markets

The growth of emerging markets within the past decade has provided an oasis of investment opportunity, in what has been a barren economic landscape elsewhere. In particular the BRICs (Brazil, Russia, India and China) have outperformed their more developed counterparts and offered a far greater return. Despite its volatility, which has traditionally discouraged pension investors, low inflation, improved credit ratings and growing stocks of international reserves has reignited interest.

However, it has been a turbulent 12 months as European debt crisis concerns coupled with global economic growth uncertainties bolstered inflation rates beyond expectations, and resulted in many major global financial markets closing well below 2010 year end levels.

Despite this setback, funds into the BRICs have increased over recent months leaving an optimistic prognosis for the next year, according to FTSE Group managing director of India and global relationship management Rohtas Handa.

“In the last five years, the FTSE All-World Emerging Index has outperformed the FTSE All-World Developed Index by 42.27 per cent. At the same time the FTSE All-World BRIC Index has outperformed the FTSE All-World Developed Index by 33.21 per cent,” he says.

Fortunately, this is a trend which looks set to stay, according to Lazard emerging markets allocation fund manager and emerging market multi-strategy team leader Jai Jacob.

“We believe the case for continued economic growth in emerging markets to be much higher than that of developed economies for the next few years is clear, as their domestic consumption continues to be strong. Intra-emerging market trade is an ever larger proportion of their exports; that growth also appears to be increasingly self-sustaining which we believe makes it a compelling investment opportunity.”

Few emerging markets are more compelling than the BRICs leading market and the world’s second largest economy, China. For the past two decades it has been consistently exceeding 10 per cent annual growth while maintaining low government debt and attractive asset valuations. Growing domestic demand has also been an important growth driver for China, according to Allianz Global Investors CIO global emerging markets Dilek Capanoglu.

“China always seems one step ahead in this regard. Already well industrialised, it now can focus on further strengthening domestic consumption as the next growth driver. We are convinced that this decade is going to be the decade of the emerging consumer and the global economic balance will shift further towards emerging markets,” says Capanoglu.

Despite such optimism, a recent report by the International Monetary Fund (IMF) predicted a slowdown in China’s growth to 9.4 per cent from 2012 to 2016. While this still puts it head and shoulders above the other BRIC economies, it seems this rapid growth has come at a price, according to Dragon Capital CEO Dominic Scriven.

“Rapid growth has led to asset bubbles that are difficult to control. What’s more, increasing demand for labour is putting significant inflationary pressure on wages. Despite this, China remains widely accepted as an important and attractive investment destination,” says Scriven.

Fellow BRIC economy Brazil is also attracting investors due to a decline in its valuations, combined with the country’s ability to stimulate the economy with both monetary and fiscal policy, according to Barings head of global emerging market equities Roberto Lampl.

“Brazilian banks are attractive, as concerns about rapid credit expansion are overstated, while the banks are well capitalised and have managed risk very well. Moreover, credit penetration, around 48 per cent to GDP, remains well below international standards,” says Lampl.

However, after a disappointing 2011, some investors believe the BRICS have reached their peak of economic growth and they are now looking towards the frontier markets such as Vietnam, which has succeeded in delivering the second fastest growth rate in the world over the past 15 years, with per capita income increasing from $280 in 1995 to $1,360 in 2011, according to Scriven.

“This increase in wealth has underpinned Vietnam’s economy where consumption is 68 per cent of GDP compared to 35 per cent in China. More importantly, Vietnam is more advanced than China in terms of its economic restructuring and deleveraging, which has allowed it to deflate its asset prices after years of high economic growth,” says Scriven.

Asia as a whole is performing well, especially on the sovereign side, says Sciens Capital head of emerging markets strategies Masahiro Onizuka. “Some Asian countries (such as Indonesia) have been upgraded while some traditionally ‘risk-free’ sovereigns are moving in the opposite direction.”

With lower market capitalisation and liquidity than emerging markets, frontier equity markets are beginning to appeal to pension fund investors seeking high, long-term returns and low correlations with other markets.

“On the equity side, many of the frontier markets offer attractive long-term opportunities, due to a combination of favourable demographics, increasing urbanisation, infrastructure demand, rising consumption, and strong production and exports of commodities. They are also undervalued relative to mainstream emerging markets,” says HSBC Global Asset Management head of European consultant relations Chris Gower.

One such market is Qatar, according to Alliance Bernstein emerging market multi asset investment team member James Ross. “From the smaller countries Qatar is worth highlighting. It was the fastest growing economy in 2011, has a sixth of the world’s gas reserves and double the US GDP per person,” he says.

Despite an optimistic outlook for many of the emerging and frontier markets, pension fund investors cannot afford to overlook the potential risks, such as political instability, poor governance and liquidity. Economic problems in Europe and the US could also impact these markets, says Jacob. “As political risk is largely unable to be diversified, equity market correlations have remained exceptionally high due to elevated political uncertainty in the US and Europe. The level of political risk and uncertainty will continue to be an important factor to monitor in 2012.”

In a bid to mitigate these risks Parametric Portfolio Associates chief investment officer David Stein suggests investors rethink their approach. “This boom and bust journey has made it hard for any one actively managed approach to produce consistent long-term outperformance. As such, rather than speculating on which markets or sectors will be the next winners, we believe that pension fund investors would be well served by adopting a structured approach to investing in the region.”

As a result there is now a growing consensus towards a multi-asset approach within the pension sector. “Pension funds and other institutional investors are increasingly recognising that a combination of bonds and currency can offer very high risk adjusted returns,” says Stratton Street Capital portfolio manager and executive partner Andy Seaman.

Blending investment strategies together to create a more diversified portfolio of equity, currency and fixed income securities can help reduce risk and improve returns, says Jacob. “By combining equity, debt and currency strategies and readjusting allocations according to economic and market conditions, it may be possible to avoid the extreme outcomes typically found in emerging markets to create steadier patterns of returns for clients,” he says.

Needless to say this is an appealing prospect at a time when many pension schemes struggle to reach adequate funding levels. “We think that challenges facing pension funds are particularly acute. Some pension funds run a deficit and at least some of this will have to be filled by performance. However, the range of plausible options to achieve this in the developed markets has become smaller as above. We feel that they are increasingly coming to the view that a major rethink of asset allocation is necessary,” says Onizuka.

To this end, increased allocations within the equity and debt markets seem likely, according to Calamos. “Over recent years, we have seen investors increase local currency emerging market debt allocations and we would expect in the future that we will see further development of corporate debt markets in emerging economies.”

However, the investment strategies of each pension scheme will depend largely on the investors tolerance for volatility, says Pictet head of institutional business Simon Males.

“Emerging markets debt, for instance, is an attractive investment option for those who prefer a less risky way of benefiting from the economic dynamism of the developing world. Emerging market stocks, meanwhile, offer the prospect of higher returns, although company-specific risks need to be monitored closely.”

Despite these risks, the next 12 months is off to a promising start with high levels of macro stability and good domestic and growth dynamics, says Dilek.

“The emerging markets catch-up process obviously still has a long way to go and supported by further stimulus, we expect economic growth in the emerging markets to remain strong. We firmly believe that emerging market economies will continue to gain in importance in a global context as the developed world heads for a period of muted growth.”

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