BackRise and fall of global emerging markets
The initial MSCI Emerging Market Index had Malaysia with the highest weightage at 29%, India entered the index in 1994 and China in 2004
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Roughly 29 years ago, the world of investing was set for the entry of a new asset class. A team of ‘believers’ at the International Finance Corporation (IFC), an arm of the World Bank, were convinced that investing horizon of investors, especially institutional investors needed to be expanded to include countries that are not on the radar.
As the story goes, while making the pitch for a closed-end fund to be listed on the New York Stock Exchange (NYSE), they were met with the usual stubbornness that every profitable new idea first faces. The fund was tentatively called ‘Third World Equity Fund’. An experienced international investor after one such presentation remarked, “Many of the companies are well run. But you will never get serious investors to put real money into this fund or any other fund that has an albatross around its neck such as the one you’re putting on this one by calling it a ‘third world’ or ‘underdeveloped countries’ fund. At least give yourself half a chance by giving it a better name." This is how, as the legend goes, the term emerging markets was coined.
It also brought to the forefront, Antoine van Agtmael, the believer of emerging markets as an asset class. To continue the story of the first emerging markets fund, as such inspirational stories go, this too was not without its twists. Capital International, one of the oldest and largest stand-alone asset managers in the US, wasn’t even on the list of investment managers shortlisted to manage this pioneering fund. The person who proposed its name to the sponsors of the fund, hoped to get an offer from Capital, but didn’t get the expected offer. Though the $50 million threshold required to get the fund listed on NYSE wasn’t achieved (it collected $44 million, including $4 million from IFC), emerging markets as a concept had arrived. The fund had a list of investors as disparate as the countries it was planning to invest in. This included Deutsche Bank AG, PGCM, a Dutch institutional investor, Paribas, a French Bank, pension funds of American companies, AT&T, Pactel, Bell Atlantic, and NYNEX. And all of them were willing to set sail into this brave new world of investing, yet the threshold level of $50 million could not be achieved.
Soon other asset managers followed. In 1987, Sir John Templeton launched a $100 million Templeton Emerging Market Equity fund with Mark Mobius at its helm. In 1988, the most important emerging market index, the MSCI Emerging Market Index, was launched (two years after Capital International got the mandate to manage the first emerging market fund). Investing in emerging markets started to gather momentum. Charles D. Ellis’ book on Capital International, Capital: The Story of Long-Term Investment Excellence, has a chapter on emerging markets, which encapsulates the ‘birth’ of emerging markets and provides the readers a ringside view of how key entities helped the launch of an asset class, we now take for granted.
The initial MSCI Emerging Market Index had Malaysia with the highest weightage at 29%, India entered the index in 1994 and China in 2004. Malaysia, till the Asian crisis of 1998, had consistently been among the top three countries by weightage. It was then suspended from the index after currency controls and ban of foreigners trading in its securities was imposed by the government. Over the past 10 years, the emerging market country whose weight had been increasing consistently was China. In fact, the pricking of the Chinese stock market bubble in June 2015 could be attributed to MSCI’s decision to postpone the increase in weightage of Chinese stocks in the emerging market index till September 2017. An MSCI Barra document on the 20th anniversary of MSCI Emerging Markets Index (in 2008), outlined growth of emerging markets as an asset class and the three stages through which this asset class has grown.
Period one: 1986-1994: A new asset class emerges. The resolution of the Latin American debt (Brady bonds) led to stability and economic growth in Latin America. Institutional investors started to include allocation towards emerging markets funds, and several country funds were launched—UTI launched India’s first offshore fund in 1994.
Period two : 1994-1999: A surprise hike in interest rates (remember Greenspan’s “irrational exuberance" comment?) led to a strife in the currencies of emerging markets. The Asian currencies were impacted by China’s devaluation. India made its debuts in the MSCI Emerging Market Index. And in 1999, China had created its first stock exchange in Shanghai.
Period three: 2000-2008: There was strong economic growth, stable to improving economic fundamentals had made emerging markets the drivers of global growth. Emerging markets were contributing over two-thirds of global growth. The benign US Federal reserve monetary policy, and pre-Global Financial Crisis (GFC) also contributed to this upswing. India registered its first ‘mother of all bull markets’. The high beta play was country funds which were mainly investing in small- and mid-cap companies. India had dedicated funds by managers like Monsoon Capital, Voyager, New Vernon, Helios Capital to attract smart beta investors. The 2008 crash was a reality check were most of these funds tumbled 60-80% as investors fleed country-dedicated funds. The global emerging markets were then quick to occupy the space that was vacated by country funds. As per EPFR data, total equities and bonds owned by global emerging market funds had touched a peak of $900 billion in October of 2007. After the GFC of 2008, emerging markets can now be classified into two distinct phases. The initial, 2009-11, saw a sharp rebound in the markets. This could be largely attributed to the stimulus packages in key emerging markets, especially China. Global emerging market funds registered record flows during this phase. Exchange-traded funds (ETFs) gained popularity as a low-cost vehicle to invest in these markets. The 2011-to date, is the next phase, when emerging markets stumbled.
And these are the fourth and fifth stages in emerging market investment:
Period four: 2009-2011: A giant China stimulus along with more modest stimuli in India, Brazil, Indonesia, led to a strong revival in emerging markets. Oil and commodity prices crossed their peak levels of 2007. There was hubris across emerging markets, economic macros started to slowly deteriorate. Markets peaked around December 2010. Passive funds, mainly ETFs began to gain ground. As per EPFR data, total equities and bond funds touched $1.4 trillion in May 2014. Equity emerging market funds crossed $1 trillion mark in Dec 2013.
Period five: 2011 –to date: China started to slowdown (hard, soft or a China landing?), and crude oil and commodity prices start to correct, and economic growth tapered off. Japan, after the launch of Abenomics, has become the new destination for growth investors, while value investors seek Europe. Flows into emerging markets bonds outpace equitiy flows, as the search for yield has intensified post the launch of quantitative easing (QE). India, re-energised by a strong election mandate, has become a consensus overweight, despite modest earnings growth.
Size of emerging market funds
While there is no definite estimate available of total emerging market assets under management (AUM), various estimates are available. As per a working paper published by Bank for International Settlements, based on estimates tabulated by EPFR, the total investment across equities and bonds in emerging markets should be in the region of $1.4 trillion, with equity AUM at $1.1 trillion and bonds at $340 billion. The issue is that sample size of EPFR is recognized at roughly one-third of the industry overall—EPFR tracks flows of $28 trillion AUM out of the total industry AUM of $70 trillion. Other third-party estimates, aggregate total emerging market equity AUM in the region of $3-3.5 trillion. ETFs, as has been the case in other markets, have been the fastest growing segment of emerging market flows since 2009. By some estimates, roughly 50% of the flows into equity in the US were earmarked for emerging markets, of which roughly 50% were directed towards ETFs. Between 2002-07, only 10% of all equity flows in the US were earmarked towards emerging markets. Perhaps a direct fallout of the QE policies launched in the US during this period.
Concept of global emerging market fund misplaced?
The emergence and the reliance on global emerging market (GEM) funds has been one of the key features post-2008 in emerging markets investing. Large institutions, rather than boutiques, have attracted most of the capital being allocated to equities in emerging markets. The big have become bigger, the likes of Capital International, Fidelity, Franklin Templeton, T Rowe Price, with their armies of Ivy League post-graduate analysts and veteran portfolio managers have displaced the nimble footed, closer to the action, boutiques. Furthermore, the entry of ETFs, as a low-cost investment vehicle is becoming a increasingly popular choice for investors.
The concept of a GEM fund is mainly derived from a positive correlation which the disparate group of countries under the label “emerging markets" have registered in the past. Till 2010, the movement in the stock prices of emerging markets had a close correlation, post 2011 that has not been the case (See graph: Moving apart.)
More importantly post 2011, for a GEM fund, countries with higher allocation have underperformed. On the other hand, the list of top performers has countries with lower weightage within the MSCI Emerging Market Equity Index. (Morgan Stanley Capital International (MSCI) Emerging Market Equity fund, is the most important benchmark used by global investors when bench marking performance of equity funds investing in emerging markets.) Given the strong internal compliance and strict policy regarding over or under weight the benchmark country weights, GEM funds have struggled to register positive returns. India, is a case in point. Given the weight of India in the MSCI Emerging Market Index, despite it strongly outperforming within emerging markets, a GEM fund would been constrained by its internal rules regarding being overweight on India, thus, limiting its return from a high performing country like India over the past three years.
Secondly, the economic disparity between these countries was and remain wide. Perhaps, the only common thread a Brazil has with India is the predominance of foreigners owning equity in the companies of these countries. The size and scale of these economies, the aspirations and challenges faced are vastly different. (See graph: Big difference.)
Third, one of the key reasons for investing in these markets collectively rather than individually was the fear of low liquidity, volumes, number of stocks or sectors. The size and depth of these markets have improved dramatically over the past 10 years. Institutional portfolio managers like Capital, concerned with the poor liquidity and corporate governance of companies in these countries restricted flows into their GEM funds only to the more sophisticated institutional investors like pension funds, endowment funds. Retail investors were allowed to participate in GEM funds, only post 2000.
Average daily turnover has increased significantly in past decade (See graph: Market activity.) In the calendar year 2003, only China, among the emerging markets, had an average daily turnover of about $1 billion. And now, all the top four emerging markets are above the $1 billion mark.
Emerging markets have been closely correlated to growth investing in the past. In the past three years, as economic growth slowed in emerging economies, the performance has been patchy, unlike the past when they moved in unison. Given the different stages of economic life cycle these economies are at they have different issues to address. Middle income markets like Brazil, Mexico, Turkey, China have a separate set of structural problems to address, while lower income countries like India, have a different set of economic obstacles. Disparity in performance across emerging markets should continue. In such a scenario, investing in emerging markets through an umbrella GEM fund may lead to underwhelming results. Welcome back country funds. An eager portfolio manager is waiting for the call to manage an India mandate.
Anoop Bhaskar is head-equity, UTI Asset Management Co. Ltd. Parag Chavan, research analyst, contributed to the article.
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