Investors get tactical on emerging markets

Emerging markets equities saw net outflows during the first half of 2011, as investors worried about restrictive monetary policies leading to lower economic growth, while risk aversion grew because of the political upheaval across the Arab world.

US Treasuries were a beneficiary of this risk aversion, despite the challenges the US government faces in managing its debt burden. And global investors also re-allocated funds to German equities, as the German DAX stock index surged to register emerging markets-type returns.

However, analysts believe that, despite monetary tightening in countries such as China, the underlying emerging markets growth story remains attractive, and flows will come back in later in 2011. But, having made good returns with simple BRIC (Brazil, Russia, India and China) exposure as markets bounced back after the financial crisis, investors are being much more selective about both countries and sectors.

Brazil is being increasingly detached from BRIC and instead grouped within an overall Latin America basket, while in China investors are looking at thematic indices with more defensive plays such as independent power producers and utilities.

Cross-asset strategy

There is also more demand for emerging markets bonds, with investors being offered a growing variety of local currency bond funds. With GDP growth downgrades on the way in some emerging markets countries, more investors are adopting a cross-asset strategy and moving some of their equities exposure into bonds with longer maturities.

In the fixed-income space, there is a growing universe of local currency corporate bonds which can be a good entry point for both yield and potential currency appreciation, while quant strategies are increasingly being used to adjust equities and bond exposure according to market conditions.

"There is currently more of a focus on Latin America, and for the first time we are seeing mandates from institutional investors such as pension funds which want dedicated regional Latin America equity exposure, rather than seeing Latin America as part of a global emerging markets allocation," says Rudolf Apenbrink, Düsseldorf-based head of the Europe, Middle East and Africa region for HSBC Global Asset Management, which runs a $145bn emerging markets portfolio.

"During the first half of 2011 there has been a slowdown in institutional buying of emerging markets equities, though there is still appetite and we would expect to see allocations into equities growing again later in the year," he adds.

Better prospects

When it comes to fixed income, Mr Apenbrink says investors already have substantial allocations to emerging markets bonds denominated in dollars, and there has been a more recent trend to invest in local currency bonds, for the additional yield as well as currency appreciation.

"In Brazil there are high nominal yields, and though the currency has already appreciated significantly against the dollar, the downside risk looks limited," says Mr Apenbrink.

For China exposure via renminbi bonds, the yields are lower, but investors are looking for ways to get exposure to the expected currency appreciation, and there is strong appetite for renminbi-denominated dim sum bonds sold in Hong Kong. This market has been tapped by European issuers such as Volkswagen. But bond investors remain wary of a possible surge in inflation in countries such as Brazil or China.

Last December, Société Générale Index launched its SGI Emerging Debt Long Short Index, which aims to capture the relative value of sovereign debt issued by emerging countries versus developed countries via a dynamic exposure to a long/short basket.

"The state of public finances in emerging markets versus developed countries may not yet be reflected in credit spreads, so investors going long on emerging market local currency debt may benefit from narrowing spreads and currency appreciation as well," says Marc Pantic, head of Société Générale Index. "The aim is to go long emerging markets debt and short developed country debt, which plays on this expected spread convergence."

Managing liquidity risks

In the equities space, investors remain wary of any sudden drying up of liquidity, and are looking to structured fund or exchange traded funds (ETF) providers to give them easy access to emerging markets themes while also providing good secondary market liquidity.

"In our Global Markets Emerging Flex fund that we launched in 2010, countries are selected via strict liquidity criteria. At the moment, we invest in equities in eight emerging markets countries, and have a watch list of other countries which we will consider if liquidity improves," says Nicolas Gaussel, chief investment officer at Lyxor Asset Management.

Allocations are made according to the risk level in each market, with lower allocations to riskier markets, says Mr Gaussel. If there is a major event such as the 2008 financial crisis, where emerging markets can suddenly re-correlate to one another, then the fund can shift quickly into holdings of developed country bonds.

Frontier markets

Back in 2005, Goldman Sachs came up with its 'Next 11' countries, comprising Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey and Vietnam. But investors are looking even further afield, for example at country baskets in commodity-rich countries.

One example of investor demand for new opportunities is the Royal Bank of Scotland (RBS) Mongolia Opportunity Total Return Index, which was launched in March. Mongolia has big reserves of uranium, coal, copper and rare earth metals, and has economic growth forecasts running at 15% for both 2011 and 2012.

The Mongolian Stock Exchange has one of the smallest capitalisations in the world, but privatisations and development of the financial markets should lead to equity market growth and growing liquidity.

At present, the RBS Mongolia Index targets companies with most of their business in Mongolia but listed abroad, in Hong Kong, the UK, Australia and Canada. For example, Ivanhoe Mines is listed in Canada, Mongolian Mining Corporation is listed in Hong Kong, and Petro Matad is listed in the UK.

Companies must have average daily turnover of at least $500,000 and a market capitalisation of at least $100m. The index is reweighted twice a year and, as the economy develops, there should be some sectoral diversity, and not just commodities as at present. The dollar-denominated certificates are listed on the SIX Swiss Exchange, as well as in Germany and Italy.

"It is a rules-based index rebalanced twice a year, and the number of index constituents is likely to increase in the future as new companies meet the index criteria," says Ronald Van Der Ham, custom index structurer at RBS in London.

At the moment stocks listed on the Mongolian Stock Exchange are not liquid enough to meet liquidity criteria, so the index targets foreign companies that generate at least 50% of their revenue in Mongolia or focus at least 50% of their business activities on the Mongolian commodities sector, he explains.

German demand down

For banks selling retail products in Germany, the slow flows into emerging markets equity products during 2011 stem from the simple fact that German companies are surging ahead with profitability and the DAX has been rising steadily.

Germany is the best performing European economy at the moment, and the DAX has outperformed other stock markets not only in Europe but also in many emerging markets. So appetite for emerging markets has been lower from German investors who have been able to get good returns by staying in their home market.

"If you look at the macroeconomic picture, there are growing concerns about inflation in emerging markets, and local central banks have been raising interest rates to fight inflation," says Dominik Auricht, specialist in structured investment products at HypoVereinsbank’s (HVB) onemarkets platform in Munich.

"Clearly a restrictive monetary policy is not good for stock performance, and equity markets such as China or Brazil have been quite flat this year, as investors have not been adding to their emerging markets equities exposure," he adds.

Nonetheless, HVB onemarkets is seeing demand for products such as emerging markets telecoms, or emerging markets alternative energy, and expects to see more thematic products do well as the DAX rally slows down and investors once more turn their attention to opportunities elsewhere in the world.

Similarly, private bank Vontobel has had success in both Switzerland and Germany with themed baskets of stocks such as the China Automobile Index, which is an index of 10 stocks exposed to the automobile sector. They must have their head office in either mainland China or Hong Kong, and come from sectors including auto manufacturing, car dealers, component suppliers and technology developers.

The era of simple broad BRIC exposure generating big returns is over, and a proliferation of thematic structured funds, ETFs and structured products based on emerging markets stocks and bonds is expected in the coming years.