The recent lag in emerging market equity performance compared with developed markets is luring pension funds to an asset class they see as cheap compared to its debt counterpart.
The MSCI World Index, which measures developed market equities, grew by 9.6 per cent between 2000 and 2012, while the MSCI Emerging Market Index more than trebled over the same period (see graph) – however recent EM equity performance has suffered.
“Emerging market debt has performed well of late… but EM equities interestingly have lagged behind developed markets – presenting an opportunity on relative valuation grounds,” said Kevin Frisby, investment partner at consultancy LCP.
At the same time, pension fund investors have started to raise concerns that EMD has become overvalued. Mercer’s 2013 Asset Allocation Survey found reductions in pension schemes’ overall equity allocations “have primarily been used to fund an increase in bond portfolios” with respondents citing a keenness to introduce or add to EMD.
The £1.5bn Royal County of Berkshire Pension Fund believes external currency EMD is “expensive” and local currency sovereign debt “relatively fully valued” and said despite the recent lacklustre performance, it expects EM equities to provide capital growth in the long run.
Nick Greenwood, scheme manager, added: “Given the dominance of the BRICs [Brazil, Russia, India, China] and the view that smaller emerging and frontier markets may in the long run produce greater growth, we are evaluating which markets we should target and how we should access them.”
Julian Mayo, investment director at asset manager Charlemagne Capital, said the EM “bond bull had run its course” and pointed to the low volatility offered by EM stocks. He added that certain frontier countries are showing particular strength, including Romania and Saudi Arabia, and said EM equities “have never been cheaper”.
EM equity earnings are expected to grow by 16 per cent in 2013 and 12 per cent in 2014, according to Stephen Millar, UK managing director of asset manager Skagen.
“Valuations are currently close to historic lows,” he said, “presenting an almost unprecedented opportunity to gain exposure to these markets.”
However, the motivation to buy EM equities should be capital growth and currency appreciation, “neither of which we are experiencing at the moment”, said Robert Simpson, EMD fund manager at Insight Investment. “Growth in EM is weakening and currencies are struggling, particularly against the US dollar.”
And Julie Dickson, equities portfolio manager at Ashmore Investment Management, warned that while EM equities are trading on a 25 per cent discount relative to developed markets and have greater growth prospects, "the dispersion between very cheap and very expensive stocks is very high, so investors need to be aware what they are paying for and what the relative upside is for what they are buying".
