Their time has come

Despite a looming liability crisis in some schemes, emerging markets remain underinvested by most UK pension fund assets. There is an average of only 3pc allocation toward emerging markets in pooled balanced funds, according to Mellon in December 2006.

When strong performance is so hotly desired, surely the opportunity to add it using this asset class should not be missed. The degree to which emerging market performance has eclipsed its developed market peers should alone endear it amongst pension schemes.

Indeed the long-term liability requirements of most pension funds mean that a strategic allocation to emerging markets is very prudent and justified by modern portfolio theory. The hypothesis suggests that diversification across asset classes with imperfectly correlated returns increases portfolio returns for the same level of risk or portfolio volatility.

The historical proposition for investment is also compelling. Emerging markets are home to 85pc of the world’s population, and generate 48pc of global economic output. Additionally they generate double the gross domestic product growth rate of the developed world, and despite the occasional periods of dramatic underperformance their equity markets have an 18-year history of outperforming both the US and non-US developed equity markets (Source: World Bank’s report: Global Economic Prospects 2006).

Put simply, emerging markets are simply too big and dynamic for investors to ignore. Overall, GDP growth for these countries is likely to be more than 6pc for 2006 and forecast to be close to that or above for 2007 (as per previous source). Such high growth rates support the prospects for robust earnings at companies that are evolving into world-class corporations.

More importantly the domestic economies of some GEM countries are growing incrementally. With ongoing improvements in economic fundamentals, corporate governance and return on equity, as well as higher earnings-growth prospects and attractive valuations, growth in emerging markets should outpace the developed world into the near future. Over the longer-term, demographic arguments favour emerging market countries, as populations are much younger and are growing more quickly. What is more, with rising personal incomes and an expanding middle class, these countries are expected to spearhead consumption trends in the next generation. Furthermore, global growth is shifting from being centralised on the US consumer, with demand from consumers in the emerging world, notably Asia, becoming increasingly important.

Indeed there is now a consensus that emerging markets are no longer as tied to the fortunes of developed economies, or indeed each other as they once were. For example, Brazil’s biggest trading partner is now China and no longer the US. Economic historians will also attest that the Argentine default did not have the domino effect on the rest of the emerging markets as some had predicted.

A supplementary argument for GEM investment exists in the commodity asset class. The global emerging markets are primarily located in Asia, Latin America and Eastern Europe. These markets are home to some of the world’s largest mining and energy companies. In the biggest and most liquid of these markets – Brazil and Russia – commodity companies make up a large proportion of the local equity indices.

Indeed, one of the main drivers of oil’s rise in recent years has been high demand, largely fuelled by the continued breakneck economic expansion of the developing world’s biggest economies – India and China. With sustained annual growth rates of over 7pc and 8pc respectively over the past three years, manufacturers and consumers are using energy at an ever increasing rate. Moreover, there is little sign that demand from industrialised countries is flagging. Oil producers group Opec says demand is expected to be up a million barrels a day for 2006, representing growth of 1.2pc from the previous year. Add to this the relative lack of refining capacity and limited supply of oil itself and the price hikes are still more understandable.

No doubt investors will understand the compelling proposition that investing in commodities makes, but have cooled their zeal to allocate funds knowledgeable of their historical volatility. An alternative option may be to invest in commodity producing companies, but this still carries significant risk, and buying these stocks directly is not always easy. By investing in a global emerging market equity fund, investors can gain exposure to a range of companies that benefit from increased commodity prices, with diversification benefits across stock sector and country levels.

Compelling as the proposition is, however, it is important to be informed of the risks inherent in the asset class. Chief among those is that the US remains an important influence on the health of many emerging market economies.

Indeed, US interest rate movements will have a greater effect on countries which are net borrowers, such as South Africa and Turkey. Moreover, because many emerging markets are dependant on the US market to buy their goods, there is the ever present danger that if its economy were to falter it could lead to an inevitable knock-on effect.

There are risks, and the markets may be volatile in the short term, but HSBC Investments believe that the global backdrop, as well as local market fundamentals, remains largely supportive. As the world’s economic centre of gravity shifts toward these rapidly expanding economies, then these markets will come to represent a larger share of world equity markets and of global portfolios. Indeed, the long-term investment case should still remain persuasive and those who may be rewarded are those who show a little patience.

Julian Lyne is head of institutional business development at HSBC Investments