Concerns drive search for alternative access

Emerging markets have enjoyed great popularity among investors and over the last two years in particular, money has flown mostly into those funds which have historically proven to generate strong performance.

But there are growing concerns that the Arabic world’s political chaos may spread to other emerging markets. Combined with fears of inflation in a low interest rate environment, these have driven some significant recent outflows from developing countries. Capacity issues in equity funds are also leading fund selectors to look for alternative solutions across all asset classes to invest in the emerging market story.

“There has been a fundamental shift in client preference for emerging markets and today there are a few funds that are soft or hard closed, probably because the majority of inflows, especially in the equity space, have concentrated on a small number of large and well known funds,” confirms Pascal Botteron, global head of the fund research group at Deutsche Bank. However, the growing number of local managers and boutiques, which tend to outperform the larger funds, can absorb future inflows, he says.

For a big bank like Deutsche, investing in smaller funds is often not a viable alternative, as that would mean owning the fund, which would impact liquidity and performance. The solution that the German bank is currently examining is a fund of emerging market funds, which is expected to be launched at the beginning of April. This product will also have a capacity cap, says Mr Botteron.

He expects a number of regional or specific themes to catch investors’ interest. “To enhance our product offering and meet client demand, we have identified managers that play themes, such as domestic consumption or the urbanisation of emerging markets, which generates high demand for infrastructure, or those linked to the commodity story, where we offer investment solutions in the mining space,” says Mr Botterton, adding that single country funds such as Brazil, China or India are also popular.

While local companies are preferred to gain generally better access to local knowledge, the large established firms, which have long history, infrastructure and expertise, and can also have local presence, are recommended to gain exposure to the more global emerging markets theme.

The issue from a due diligence perspective is that, in emerging markets, hedge fund firms do not have the same standards of infrastructure as their counterparts in London or New York, says Mr Botteron. Risk systems and governance aspects can be insufficient, and small hedge funds often consist of just two or three traders and a Bloomberg terminal.

“We are conservative in our selection process and see increasing demand for absolute return funds that are both liquid and secure,” says Mr Botteron. “We are offering solutions in the Ucits III and managed account spaces, clients are receptive to both vehicles and have shown a lot of interest in our emerging markets funds in particular.”

Both long-only and absolute return products have their role in investors’ portfolios. With a long-only exposure in emerging markets, on the equity or bond side, an investor can really capture the emerging market growth story, he says. Emerging markets hedge funds are good instruments for their ability to short stocks. “Emerging markets can be viewed as less efficient than their developed counterparts, as a result there may be more opportunities to generate alpha. Many companies and sectors within emerging markets do not have a large volume of analyst coverage, as a result managers based in the region, or those with strong local knowledge have an advantage.”

The third reason to invest is related to local market expertise. “It is no secret that a lot of talent tends to end up in hedge funds because compensation and remuneration is sometimes more attractive than in mutual funds,” says Mr Botteron.

Emerging markets, traditionally hit by many shocks and catastrophes, are notorious for their high volatility, so the ability to go short can generate great outperformance, compared to an active approach or, worse still, a passive approach, according to hedge fund managers at GLG Partners.

“In emerging markets, the tails are fatter and the skew towards the downside is bigger and if a manager goes short into just one of these crises, capturing half of the returns of the collapse down, that will generate massive outperformance,” says Karim Abdel-Motaal, co-fund manager at GLG Partners. “Our job is easier than that of our peers in the developed world. Nothing will remove the need [for a manager selector] to find the right manager, but it does remove it somewhat more than it does in any other asset class.”

Hedge funds can better smooth volatility in a particular period which has encompassed huge market draw downs, but in a liquidity driven boom market, active funds probably do better than hedge funds in the main, believes Rupert Robinson, CEO of Schroders Private Bank in the UK.

“If you are concerned that markets could go down, in terms of the odds, as much as they could go up, then maybe a hedge fund vehicle is a better investment. But over the long-term in emerging markets, I would rather be naked long, because you are investing in the region for long-term growth, and therefore you do not want to control the downside risk.”

One of his favourite absolute return managers is Sloane Robinson, which has been very successful in managing equity long/short money in the emerging markets space, he explains.

Exchange traded funds are very cost effective instruments, allow efficient implementation of an asset allocation view and are used when a particular manager cannot be found to fulfil an investment brief or a mandate, but in emerging markets, if one is taking a long-term view, a good active manager should be able to do better than the index and be able to add value, given the opportunity set, says Mr Robinson.

It is also important to be able to assess market opportunities and adjust portfolio exposure. “My experience in emerging markets is that you need to buy them when they are extremely unfashionable and unloved and sell them when they have become over-owned and they are on everyone’s portfolios to a high weighting.”

Periods like 2001 to 2002 or March 2009, when the market corrects violently, are the periods when investors need to buy them, says Mr Robinson. “I really believe there will be great buying opportunities in both the Chinese and Indian stock markets this year, and you can bet that at that time everybody will be saying ‘get out of emerging markets’.”

Supply can stretch to meet demand

The bulk of global economic activity – 53 per cent of GDP on a purchasing power parity basis – is in emerging markets and capital markets are very small in comparison. A manager may have a specific capacity issue but that does not mean that there is lack of things to buy, says Jereme Booth, head of research at Ashmore Investment Management. Capacity issues should not have an impact on the attractiveness of emerging markets as an asset class. “One of the main motives for emerging market investing is to reduce risk, not just to increase return,” says Mr Booth. “What amazes me is that often people invest in equities before they do in fixed income. The capacity in fixed income is huge and in real estate is absolutely massive.”

Elasticity of supply is very significant, particularly in corporate debt, and supply will grow at the same rate as demand, he says. “These markets, particularly in corporate debt, but also in local currencies sovereign debt, are very nascent, but they are growing very fast.”

In the equity space there is also elasticity of supply, although less marked. “In many countries like India, the number of companies that could do an IPO is just enormous,” says Mr Booth. “We have already seen, in the last couple of years, vast growth in IPO markets in some of the bigger emerging markets. As that continues, the universe grows.”

Real assets are very attractive. India’s planned investments in infrastructure over the next five years is $500bn (E370bn) and it could be double or three times that, as there is a lot of local speculation, he says. “There is no end of potential for building infrastructure in India. The whole of India has got just the same amount of hotel rooms as London, there are huge numbers of entrepreneurs wanting to build factories, employ people, create real growth and they can’t, because there are no roads, no telecoms and no water supply. If you have an infrastructure boom, you get a manufacturing boom in three years.”

Investors cannot invest in real estate directly, having to work with local partners, says Mr Booth. “For private equity investors, investing in emerging markets just to provide capital is no longer good enough, because these countries have a huge amount of savings. You need to provide expertise, access to third markets or economies of scale,” he says.