In its first roundtable on the topic, Global Pensions gathered key industry spokespeople in London to discuss investment in frontier markets
Alex Beveridge: What is driving investor interest in newer and less well-known markets, and how can we measure this interest?
Joanne Irvine: The growth opportunity is the key driver. These economies or countries have abundant natural resources and attractive demographics. There has been a structural credit improvement, which has been combined with fiscal and corporate reforms. This has led to improving economic fundamentals in many of these frontier market countries. Another point would be that they are less correlated with global equities. In the last few years, emerging markets as a mainstream asset class have become quite highly correlated with mainstream equities so frontier markets can give diversification benefits as well.
Alex Beveridge: Debbie, in terms of your clients, have you seen an interest?
Debbie Clarke: Yes, we have certainly seen an interest from US investors. I would agree with Joanne that, particularly for pension plans, the key advantage is diversification. So many emerging markets have started to behave like developed markets that people are looking for the next area to invest in. However, one issue we have with frontier markets is perhaps capacity for clients. I am sure we shall talk about that later.
Chris Sutton: On the correlation point, you need to be a long enough term investor as correlations can disappear when you need them the most. You would almost characterise this as a private equity type opportunity.
The opportunity in frontier markets is for them not to be frontier any more. It is for them to emerge and perhaps one day develop, so this is a potentially diversifying opportunity within a private equity style mindset.
David Da Silva: The opportunity set is certainly something that is attracting many investors but it is also unfortunately true that the diversification benefits have deserted people when they needed it most.
Joseph Mariathasan: May I just add something else which I think is quite interesting. If you look at the fundamental drivers, it is what I call the triumph of economic liberalism, in other words globalisation. The WTO and so on have transformed the economics and to some extent the politics of a whole swathe of countries, which is the reason you are getting a middle class guy in some supermarket in Bangladesh thinking he can buy a product that 10 years ago would have been inconceivable, it would have been a product imported from somewhere else.
That also perhaps underlies some of the dangers in frontier markets in that the world, as it stands today, is on the cusp of either the US continuing to maintain free trade, or potentially reining in on itself and saying we are going to protect American jobs even at the expense of undermining free trade. Therefore, I would say there is a dark cloud hanging over all markets, particularly frontier markets, and the significance of this will be driven by the impact of Barack ObamaÕs economic policies going forward.
Chris Sutton: I think the next stage of the China story is important there as well. You talk about resource-rich economies, many of these are part of the Chinese land grab for resources and these frontier markets support Chinese economic growth. At the same time other frontier markets are competing with China to be the next lowest cost producer in South East Asia.
Alex Beveridge: Could I just bring in Chris or David, because you are creating products to index these markets. What is your view on what is driving investor interest?
Chris Broad: First, I would echo from the product provider point of view everything that we have heard. This is the reason why we and other providers have started to deliver product to enable investors to assess and enter these markets. As a related point, an area of interest for us is how thick that seam is at the frontier level and how sustainable it is over a long period of time. It is one of a number of gradations in the classification system, and the hope is that you converge ultimately upon a developed market gold standard. Is the logical conclusion that everything flips up into emerging market status, and how sustainable is the dynamic of the frontier market?
Simon Ringrose: It is quite interesting that, although sometimes people might mix frontier and emerging in the same sentence, the actual flows this year have been completely the opposite. Whereas emerging markets have lost massive amounts in both the Asia ex Japan category and Latin America funds, the frontier market funds have done rather well up until at least September.
Alex Beveridge: I just wonder from a pension fund perspective if you are investing in a frontier market, is there a capacity issue in that there is not that much money to be put into these markets, so does it make a meaningful difference to your portfolio?
Debbie Clarke: Pension funds have much bigger issues than worrying about how much they have in frontier markets. Starting at the top, they have to work out what their liabilities are, how much they have in risk-seeking assets and how much they have in matching assets. I think it is quite a challenge to get trustees to look at emerging markets. Some pension funds donÕt have the governance to consider frontier markets. Perhaps trustees should appoint global equity managers who can make opportunistic investments in emerging markets or frontier markets?
We were talking to emerging market equity managers who made opportunistic investments in Vietnam a couple of years ago, and there have been a significant number of global equity managers making investments in emerging markets. Petrobras was probably as well owned by the developed global managers as it was owned by the emerging market managers I would have thought in the middle of last year. So there are some interesting questions around that but I believe that frontier markets, in the current environment, are not going to be that relevant for many pension schemes.
Alex Beveridge: What distinguishes a frontier market from an emerging market, and how should investors approach this?
David Hobbs: I think there are at least two aspects to this. One is the actual infrastructure of the market. Emerging markets have moved more into the mainstream, the infrastructure is less developed but it has definitely made steps, whereas frontier is still, to some extent, the Wild West of the investment market.
That creates dangers in some respects, which is why one needs some sort of objective assessment of the market. That is how FTSE has tackled it really in terms of using various specific market criteria to define even admission to frontiers, and there are a number of markets that do not meet standards that we would regard as suitable for global investment. That then provides the opportunities to give guidance to those markets as to what they need to do to make themselves more suitable for assessment for a global investment.
Joseph Mariathasan: May I add a quick question to David. I notice that Colombia and Argentina are on a watch list to be downgraded to frontier status. What is the background to downgrading a country?
David Hobbs: The background to those two specifically was their capital controls on movements out of the market. One of our criteria, for example, is to say there has to be free movement of capital in and out and it is largely government driven. When there are restrictions on that Ð I know that Colombia has recently reversed that but Argentina still has a situation where you have to put substantial additional funds in non-interest-earning accounts for example. We regard this as a significant constraint on the free flow of capital. That is the rationale. We would hope to explain this criteria to those markets to ensure they understand the issues and put pressure on their governments and finance ministers to reverse those situations.
Joseph Mariathasan: Do you get pressure the other way? I can understand the Argentinean government and stock exchange may not be too pleased to hear that FTSE is downgrading them to frontier status Ð is there a political angle?
Chris Broad: It is inevitable because there is a degree of profile from a PR point of view and we are in an asset-seeking situation. Therefore, exchanges, governments and quasi-governmental bodies demonstrate an interest in all of the index providersÕ specifications for that reason. We have not downgraded anybody yet, I believe I am right in saying, David?
David Hobbs: Correct.
Chris Broad: The flipside of the classification programme is that it tends to support market development. You tend to find that exchanges, whether they are independent of governments or not, are very interested in that because they want to attract capital by being grouped in the next tier, as it were.
You get people who complain at the risk of being downgraded and respond normally positively, and we get people who are stable in a particular category who lobby very hard and for the same reason they go down to the next tier. That is something about which we talk to exchanges, regulators and quasi-governmental bodies a lot rather than the asset owners who are interested in current status.
Alex Beveridge: David, from an asset managerÕs point of view, how much attention do you pay to the fact that a country could potentially be downgraded or upgraded?
David Da Silva: Predominantly, we are looking at investments from a bottom-up perspective, focusing on companies able to deliver long run returns. In addition we apply a top down overlay, considering the macro environment.
Investing in frontier markets, or in countries that have as yet not even been classified in that range, is something that we have done in our funds. The decisions are driven by the underlying fundamentals and relative valuations across the regions.
A countryÕs classification will have a bearing but it will only be taken as part of the top down overlay; we are interested in finding the best stocks across the regions. That having been said, if we see significant settlement or safekeeping risks in any of these new frontier markets, then that is an unacceptable risk, and would deter direct investment.
Joanne Irvine: I agree about delivery versus payment. We have never taken that risk so, for example, we have been investing in Russia for many years via ADRs and we have never invested in a local stock in Russia, because we would not take that risk.
We are looking to launch a frontier markets fund which will be benchmarked against MSCI which in our view is quite distorted with more than 70% in the Middle East. The way our investment process at Aberdeen works is by assessing the quality of the company and, having looked at the quality of the companies in the Middle East, it is very poor.
If we launch a frontier fund it will be very different from the index, we will have very little in the Middle East but we will be overweight in eastern European and African countries etc.
A good example of things moving out of the index was when MSCI downgraded Argentina. I believe the only stock that really has significance in that index was a company called Tenaris which makes steel pipes and is a global player. However, most of its assets and profits come from emerging markets.
So that company was upgraded to developed market status and we wrote to all our clients, because we believe that it is best in class and trades on an attractive valuation. In terms of the new fund we will have the ability to invest in any country that is not classified as developed or emerging.
Alex Beveridge: What is the value of an index provider categorising these "labelsÓ? What alternative definition systems exist for asset owners?
Simon Ringrose: Certainly, it is quite useful to advertise that these markets are open for business and that they are real. Also it helps signal the level of risk involved when you differentiate them from emerging or developed markets, so there is definitely benefit in both advertising these markets being open for business and, as we said before, a very nice growth story with returns up around 20%. At the same time, there is a lot of risk so there is definitely value in labelling them appropriately.
Alex Beveridge: What about alternative definition systems?
Simon Ringrose: In an earlier life, I was with the UN for years and they use different classifications such as less developed, developing and developed. I am not sure there is any completely right way of doing it but it is definitely useful.
Chris Sutton: The amount of due diligence carried out by index providers is more useful. We have just had the discussion about Argentina and Colombia and one of the important drivers there is that in the global indices they are being compared to the likes of Venezuela and Brazil. That is useful both in terms of the markets but also as a reference point for investors to know that those discussions are going on at the exchange and government level.
As we have already heard from the asset managers, the labels that matter are those that the asset managers themselves will invest in, as there needs to be an extra level of due diligence around operational risk.
An index provider is your first point of reference and your second is ÔinvestabilityÕ, looking at the operational level. Therefore, as far as the combination of high governance funds are concerned, understanding the risks and then delegating to asset managers who are deeply involved in managing those risks, the label that counts is whether this is ultimately ÔinvestableÕ for the fund.
David Da Silva: Yes as a reference point it can be seen as an important part of active management. The downside of this is that it can encourage herding by fund managers around benchmarks, and you can lose the originality of investing in these markets.
However, I agree that by being endorsed by the major index providers, you have to a degree the first level of country due diligence which we then pursue much more deeply.
Chris Broad: One of the questions for us is how does this develop and what is the right pace of development as well. By developing changes too rapidly, people who are either using it as a reference point or who are using it to manage funds directly will be involved in an undue amount of change and churn.
What we are really interested in is how the criteria and the framework should be developed. At the moment, it is an instrument which is, I would say, at the early stage of its development. We have these 21 criteria and these different classifications. The question is how should we develop it to make it a more useful instrument for asset managers? Do we have the next big development of that framework ready to be pulled out of a hat? No, we do not, because it needs to be stable.
Joseph Mariathasan: May I put a completely different viewpoint on this issue? One of the fundamental problems in the use of any index is that people confuse what an index is for. It can be used as a representation of market movements; as a basis for providing derivative instruments; or as a measure of risk in some sense.
The problem is that the definition of risk is very different from a pension fund and a fund manager. So sticking close to the index minimises a fund managerÕs risk because it minimises the risk that he gets fired for underperforming against the index.
However, sticking close to the index has absolutely zero relevance to a pension fundÕs risk profile. Debbie Clarke: The only thing I would say is that at least the index will give you some reference as to what the risk is for that group of assets. Why constrain managers to anything in terms of whether it is developing, emerging or frontier?
It is better to give managers as broad an opportunity as possible. However, most clients want something they can measure a manager against.
Joseph Mariathasan: A fund manager is primarily driven by minimising their own business risk which is a very different risk from that faced by a pension fund.
Debbie Clarke: Yes, I agree, the pension fund risk needs to be discussed in terms of its strategic allocation etc.
Joseph Mariathasan: The fund managerÕs risk is minimised by not deviating away from the index, whereas the pension fundÕs risk may be quite the opposite. Let me give you a very good example. During the TMT bubble, pension funds in the UK had 70% of their assets in equities and half of that would be UK equities.
Vodafone was 13% of the FTSE100 index, so a typical UK pension fund may well have had 5% of their assets in Vodafone. For the fund manager who went from 13% to 10% he could think he was underweight in Vodafone in terms of his risk, whereas for the pension fund to have 4.5% in one stock, by any rational reason, would be overweight. So you get a completely opposite definition of risk because of the index.
Chris Sutton: A key driver here in these markets is an understanding on the part of the pension fund as to why they are making the investment in the first place. For instance, I could see two very different economic rationales for making an investment in frontier markets. One is about frontier markets moving into emerging and another is about economic growth and emerging middle classes. It strikes me that those are quite different economic rationales and may lead to quite different investment portfolios. If you are investing because you expect some transition, the index is probably a highly liquid and ÔinvestableÕ way of making that transition.
A portfolio which looks somewhat like the index, with some operational oversight, may well be the best way to take advantage of any transition from frontier to emerging. If instead you are investing because you want exposure to the emerging middle classes, or to the land grab in basic resources, then you may not want to invest in the index, you may well want to invest in something slightly different. However, it all comes to investment rationale and governance, plus awareness of risk.
David Hobbs: I would have said that there is a rationale for having an index even if you do not want to use it as a benchmark. It does provide a measure that you can use for analysis of the performance of the stocks in the market, and their risk in terms of volatility and their correlation.
Debbie Clarke: Pension funds need to go back to the rationale of why they are investing and, as you say, hopefully learn something from not having 5% of your portfolio in Vodafone.
David Hobbs: Let us add to that point. If you are running an active investment portfolio, you would want to make individual stock decisions and you would look at the individual characteristics of the market. However, that has constraints as was mentioned earlier in terms of liquidity, because these typically are relatively small companies and certainly the ÔinvestableÕ capital in these stocks is quite low.
Even if you are a large company, the amount of money you can invest is typically quite small. Therefore, one way of investing, if you regard frontier markets, or indeed emerging markets, as an asset class you want to invest in, is that you need some diversification as far as the investment opportunities to be able to put your money in reasonable quantities. As the index is based on ÔinvestableÕ cap and includes some sort of liquidity hurdle, it gives you an opportunity set that you can use if you just want to invest in the market.
Alex Beveridge: To what extent should investors seek to influence the environment and financial policy of developing markets?
Chris Broad: I would have thought it should be part of an active managerÕs business to seek out additional asset classes or markets which are available for inclusion in a portfolio. If you follow that argument, as I do, the conclusion would be, yes, there should be active involvement.
Brokers and other agents may have different reasons for being involved as far as their own margins in the process, but they have deep operational experience of the trading end. Their involvement is valuable in getting a good outcome as far as the accessibility of markets. I do not see a downside to having a full involvement from brokers and from fund managers in the process.
David Da Silva: Historically, stock markets have been very efficient ways of raising capital and it is in the interests of these frontier markets that their stock markets develop and have foreign investor interest as well as domestic interest. Therefore, anything that encourages that participation and nurturing of the industry we would be very much in favour of.
Debbie Clarke: One of the things Chris talked about earlier on was looking at this as similar to a private equity, long-term investment. That creates the opportunity in which there should be engagement with companies in terms of how they develop their business. Investors will have to be more involved in engaging with companies in frontier markets and understand the Environmental, Social and Governance (ESG) issues in depth.
Simon Ringrose: I would just stress that it is in our interests to encourage good local research and adoption of useful technology as well as helping the local investors see the risks and rewards of being part of the global financial system. That is partly self-serving but it is also good for the local market.
Joanne Irvine: Our policy at Aberdeen is that we engage with companies particularly on issues like governance and the whole ESG area, which is a key part of our process. We will also take further steps where it is appropriate. For example, over many years we have been canvassing the stock markets in Latin America to give minority protection to shareholders in a bid situation. At Aberdeen we engage with companies all over the world on ESG issues.
Alex Beveridge: Do you feel that you get a measure of success from doing that?
Joanne Irvine: Yes, and the companies in which we invest are only companies that meet our very stringent quality criteria. We engage with companies and, if there is no improvement, we do not invest.
David Hobbs: Picking up on that point to a degree, investors may not overtly but indirectly seek to influence the environment and financial policy by choosing what companies and which markets they invest in. Therefore, they will only invest in companies they feel are attractive and those companies will be put on a higher rating than those that are not selected. That, in itself, will put pressure on markets and companies to change.
Alex Beveridge: And you see evidence of this as well?
David Hobbs: I think so, certainly within the markets, because all the markets that we have in our indices or in our watch list almost invariably are keen to engage and understand the criteria. Also, going back to an earlier point and without wishing to repeat it unduly, investors pick up governance issues particularly on things like operational risk, which tend to be more market-oriented rather than company-specific.
Alex Beveridge: If pension funds are making an allocation to emerging or frontier markets, are they looking for the fact that their asset managers will be engaged in these issues?
Chris Sutton: Absolutely. Particularly around protecting shareholder rights. Again, we are talking here about pension funds that have already done a degree of research to get comfortable about investing into these markets.
If you do have the resources needed, you very quickly understand that minority shareholder rights are a big issue. Do you want your asset managers to engage on this? Absolutely, as it is a fundamental part of the management of these portfolios. I doubt you would want to hire an asset manager who was not both resourced and skilled to do that.
Alex Beveridge: Simon, do you have anything to add on this?
Simon Ringrose: On the influence part? I agree that it is in our interest to take part in the governance piece, the training piece and encouraging local research of these companies is in everybodyÕs interests.
Alex Beveridge: What does it mean to the frontier and unclassified markets in having this structure? Does it have political influence if a country is downgraded?
Joanne Irvine: When I speak to companies in the Middle East, they really feel they should be classified as a developed market.
Debbie Clarke: Do they have some sensible criteria as to why they believe they should be developed?
Joanne Irvine: Because of the oil wealth. On a GDP basis, that is their argument.
David Hobbs: That is one of the main factors we get. In the initial discussion we have with the markets, regulators and financial ministries, the question we are asked is why are we not more highly rated than we currently are?
An example that I would use which goes outside the frontier of how the influence works is in Greece where we have had them on a watch list for several years for downgrading from developed to advanced emerging.
We have had discussion with all those parties and they are very conscious of the fact that they do not want to be downgraded, so they make big efforts to try to meet the criteria. We are not inventing these criteria, we are attempting to collect what investors tell us they want.
David Da Silva: It is important to note that, despite a country being downgraded, it is not necessarily the case that the asset manager would automatically liquidate the positions. It is dependent on our interpretation of what the macro fundamentals are. As it happens, we are in agreement with Argentina and you are right that Tenaris moving out has just made the decision easier.
The fact that a country is classified, or not, is almost irrelevant. We will conduct our own analysis and adjust the risk premium accordingly, as far as the opportunity set, we would still consider them.
Alex Beveridge: Moving between market designations, what is the impact of a designation change for markets and investors? If a country looks likely to be downgraded or, indeed, upgraded, do we suddenly see big capital shifts with people either rushing to get their money in or out as a result of that?
Simon Ringrose: In terms of flows definitely. Korea is one of the most talked-about ones at the moment.
Just being moved into an index helps short-term inflows or outflows and changes in portfolio manager divisions, and people will trade off that, particularly the hedge funds.
Alex Beveridge: So people will take bets well ahead of time if a country is about to be upgraded or vice versa?
Simon Ringrose: Exactly.
David Hobbs: In the end, classification will have maybe some impact but it will only be minor and probably only short term. Certainly, changes will only have a short-term impact because if companies are overrated, they will be sold. Also the change in designation does affect the type of investment and the type of investor. Moving from frontier to emerging, or from emerging to developed does raise the profile of the market. Here we perhaps bring in the index trackers as well. There is an automatic flow but it will only have a relatively short-term impact on the rating I believe.
Debbie Clarke: Looking at frontier markets, I agree there will be companies that move from frontier and emerging to developed but I am not sure that I agree that, as countries become more developed, it will necessarily mean the new investors are long-term holders. With frontier markets, you need to have a long-term perspective but I worry that, as countries move to the developed indices, there will be more short term players involved.
David Hobbs: There are short-term players but there are also longer term investors who buy and hold because they have to.
Debbie Clarke: Yes, because they have to but I donÕt see why that wouldnÕt also apply to investors in frontier markets Ð my suspicion would be that investments in frontier markets will have to be made with a long term perspective.
David Da Silva: Absolutely in agreement. To add to this I would think that passive investors are much more likely to create flows in and out. We saw a change in the free float of Gazprom a few years back, and it had a massive impact on the relative country and regional weights; pure index trackers would have had to adjust their holdings considerably as a result.
Alex Beveridge: One thing for Chris and Dave from FTSE, do you come under pressure to reveal information ahead of time?
Chris Broad: No, most people understand you cannot tolerate that kind of information asymmetry. We do not get any serious lobbying for the information but we get serious lobbying from markets and exchanges before the change itself, which is part of the creative process if you like, but the information leakage no.
Alex Beveridge: As equity markets move up the spectrum from nascent to frontier, and frontier to emerging, and so on, are there other nascent equity markets to replace them?
Joseph Mariathasan: No, but there are some interesting markets. For example, one of the companies I am associated with is acting for a Cambodian private equity firm. Cambodia stock exchange will be launched on 9 September 2009 which is an auspicious date for the Cambodians. There are a number of countries in Southeast Asia that look quite interesting from that point of view. Cambodia is probably the furthest advanced moving from a situation of no listed companies to preparing to launch a stock exchange.
However, if you look at countries like Laos and even Myanmar at some stage, once they get through their political issues, they may be interesting.
Chris Sutton: There probably are new markets but the bigger need is to go deeper in existing markets. We have talked already about markets that are dominated by one stock, one industry, and financials are a big part of frontier markets. Given the extent to which funds are making an investment based on some economic rationale about economic growth or growth of the emerging middle classes, my request to index providers would be not to go and chase the next market but to deepen exposure in existing small emerging and frontier markets.
Debbie Clarke: Do you not tend to get that when you first see the frontier markets, they tend to be dominated by financials and telecoms. One of the thoughts I have about this is whether any of the new countries have the domestic market that the current emerging markets have in terms of market size to be able to develop enough of a domestic market to make an impact.
If you look beyond the countries that are currently classified, I would worry whether or not any of those markets will have any significance, as their population is just too small.
Chris Broad: Because the focus over the last 10-15 years has been in terms of looking beyond developed and putting strata into emerging, and now frontier, the pace of that cannot continue. It is a 20-30-year horizon about what is beyond frontier markets rather than a five-year horizon which has been the horizon for frontier.
It is tempting to say we have done frontier, so what is next but the fundamentals do not support that kind of extension, so it will not happen in the same way. Over a longer timeframe, it is reasonable to expect there will be promotion from frontier to emerging, and promotion from nascent to frontier, or the creation of something beyond frontier.
Joseph Mariathasan: One of the fund managers that I am associated with is an emerging market fund of funds called Old Square Capital and I am just looking at some of the countries there. They have invested in Saudi Arabia and they have a list of an expanded universe. It includes countries like Mongolia, Cambodia, Azerbaijan, Tajikistan, Turkmenistan Ð there is a whole host of these alongside countries like Saudi. They are not going to be the next China but there is an interesting number. The great thing about the frontier markets is that they are so uncorrelated to the mainstream. For example, Old Square has a third of their whole emerging markets in these frontier markets because of the lack of correlation.
Just in terms of geographical regions, I am intrigued as I have noticed in the last couple of years people talking about the African renaissance. If you look at the list of companies that Old Square Capital are looking at, there is a whole host of sub-Saharan African countries that are now having emerging stock markets. Is that something that you have been noticing?
David Hobbs: Yes, I think so. In the index we need other things like reliable prices, things which an individual investor does not necessarily have to pick up on, so there are some fairly basic criteria that we have to regard as minimum in terms of information available that can be used to construct indices.
Obviously, liquidity is a key one so even where you have companies, if there is no stock available for outside investors, there is not a lot of point in putting them in the index.
David Da Silva: Just to pick up on JosephÕs point, a country like Angola is seeing substantial economic growth mainly on the back of oil and growing trade links with the rest of Africa and China in particular. It is in the process of developing a stock market but has some way to go before becoming a fully fledged diversified investment opportunity.
The dominant sectors in emerging markets tend to be financials, energy and resources and it is likely that Angola will also be very concentrated in a few of these areas initially at least. Providing the political situation and the system in place retain the current positioning, we believe it has tremendous potential.
Simon Ringrose: I was just going to say that, before we run out of countries to talk about, there are other non-geographic frontiers in which investors are interested. We get asked a lot about flows into investable themes, socially responsible investing, green investing, Shariah investing and so forth.
To some extent, in terms of relative importance, there will be these investable themes in which people are equally interested as well as the new geographic frontiers you are talking about.
Alex Beveridge: Will we ever reach a stage where all markets are classed as developed? What then? By the same token, will there ever be a need to distinguish between developed markets, creating sub-categories within that Chris Broader category?
Debbie Clarke: Last year the answer might have been yes but I am not sure this year.
David Hobbs: The assumption is that the qualities required for developed status in the future will be higher than they are today. It is not so much a case of moving the goalposts but of trying to improve the overall standards really.
Joseph Mariathasan: It is worth noting that the credit rating of Botswana is about the same as that of Italy, which shows you the relative changes in the world that you are now seeing. Therefore, rather than having an emerging market index, you may have a submerging market index!
Alex Beveridge: Many people have argued the weightings within global indices have traditionally under-represented emerging markets Ð is there an argument that markets (and therefore investors) are bound too tightly by these definitions?
Joseph Mariathasan: Definitely. One of the interesting graphs I saw was a chart that weighted emerging markets by GDP rather than by cap, and that shows that over eight years from 2000, a GDP-weighted emerging market index would have outperformed by 30%. I remember telling Alex Beveridge that my 12-year old daughter could have then beaten the index by adopting a GDP approach to emerging market investment.
The other point to make is that emerging markets are currently 8-10% of the MSCI index, 20 years ago they were probably 2% and in 10 or 20 yearsÕ time they may be 30%. If you are a pension fund, at what point in that time horizon do you set your weighting? Will it be 20 years ago, now or for the future GDP weighting?
In other words, pension funds are effectively taking a backward looking view in their emerging market allocation. I would argue strongly that emerging market allocations are better off adopting a forward-looking allocation.
Alex Beveridge: Chris, are you advising any of your clients to go to 20% in emerging markets?
Chris Sutton: We need to distinguish between two things. Have the indices under-represented emerging markets? To some extent according to their rules, no, the market cap of these markets is smaller than the market cap of developed markets and you cannot wish that away.
Are there opportunities for long-term investors to take different weighting schemes from market cap and take benefit from that Ð GDP is one; some sort of tiered equal weight is another which we have seen? Yes, absolutely or at least historically. There is a place for non-market-cap weighted international benchmarks.
My one caveat about this is that my current learning from the credit crisis is to throw away much of recent history. I was not working in the 1930s and, unless there is anybody in the industry who was, strategies based on our own experiences are in danger of being misplaced.
The next five years are unlikely to be like the last 20. I can build an intellectual case for a different weighting scheme in international equities but I am not utterly convinced that the last 20 years will be repeated in the next.
Debbie Clarke: When we have assessed emerging markets, we view them as a strategic asset allocation for clients that have the appropriate governance. Typically, in the past we have recommended a 10-15% weighting.
I also agree with Chris that pension funds at the moment are going to have lots of questions about equities full stop, wherever they may be invested. Coming back to something that David said earlier on, as far as the diversification benefits of frontier markets, in dire markets the liquidity profile and typical dependence on global growth has meant that all those markets have come down together, i.e. the diversification benefits are not there when you need them.
If you look at the performance of frontier markets, it had held up well but then has been very weak for the last couple of months. If people feel comfortable with equities, I believe there is a place for having a strategic allocation to emerging markets but it is a very long-term holding and I would see an appropriate range as 10-15%.
David Da Silva: To pick up on JosephÕs point about emerging markets being about 10% of global indices whereas the economies in a GDP-weighted sense are about 25% of the world economy.
We have seen there is a strong relationship between an economyÕs size versus the global economy and market cap versus the global market cap. A very good example is in the late 1980s in Japan when Japanese stock exchange listed equities were 50% of global market capitalisation, whereas JapanÕs economy was only 15% of the world. When the bubble burst, it took 10 or so years before it eventually settled at the level of the size of the economy, which is around 10% and that is where it is at the moment.
So we would expect to see a trend for emerging stock markets to raise their market cap weight towards their economic weight of 20-25% of world markets, and in so doing demand far more detailed and dedicated attention from institutional investors.
David Hobbs: Just coming back to the first part of the question, global indices represent the investable opportunity set, and they are not intended to tell anybody how they should invest.
The fact is that 20% in emerging markets might be a good goal but one or a few investors might be able to achieve that but the whole community of investors certainly cannot. Coming back to ChrisÕs earlier point, what we need Ð and perhaps the index providers can help to some extent Ð is deeper markets to enable the investable opportunity set to grow as the economies grow and the more companies that come to the market, perhaps a higher proportion of these companies are available to international investors. As that grows, then their weighting in the indices will follow that.
Joseph Mariathasan: That also goes back to the definition of risk. People are being brought up with the modern portfolio theory and the idea of efficient markets, so there is still the implicit belief that the market of which the global universe is an approximation is the minimum risk position in some sense.
Therefore, for the pension funds the minimum risk position in equities would be to have the market cap. However, it is not necessarily the only view and that is the point I would make.
It is the view for the sum total of investors but the pension fund universe is only one element of it. It also has much longer time horizons than most other investors. They can therefore afford to take a forward looking viewpoint and be less subject to the vagaries of short term volatility.
David Hobbs: The corollary to that is that because of the lack of research and so on, the frontier markets are almost certainly less efficient than the developed markets. The developed markets are probably over-researched and, therefore, the opportunities for added value of the alpha in those markets are relatively low. However, the opportunity for alpha in emerging markets and frontier markets would seem to be high. That would argue, I guess, for there being more opportunity for higher returns, at least in the shorter term, from these markets than from those where the research is pretty high.
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