Retirement investing: longing for yesterday

With their focus on developed economies, pension funds miss out on emerging market returns, says Jerome Booth

The claim that institutional investors with long-term horizons should hold more than half their assets in emerging markets would be dismissed as foolhardy, even reckless by many experts. However, that’s exactly what pension funds should do, according to emerging markets specialist Jerome Booth.

Most pension funds probably hold less than 5-10% of assets in emerging markets for reasons that Booth calls “core-periphery disease.” Rooted in a mixture of prejudice and misunderstanding of risk, it could cost pension funds’ members dearly, the founder of New Sparta Asset Management and former head of research at Ashmore Group warns.

Many investors hold to the idea that emerging markets exist at the edge of the global economy and revolve around its “developed” core. That belief is likely reinforced by the dominance of the US Dollar and the importance of the US Federal Reserve in global financial markets.

This overlooks the fact that the US share of the global economy is ebbing and now stands at 22% from around 36% in.

The dynamics behind emerging countries, such as higher economic growth and less outstanding obligations, favor higher returns over the next 15-20 years compared with developed economies. This has implications for future pensioners. Booth believes that over the long-term, emerging market assets are more likely to preserve capital than assets such as index linked bonds issued by developed countries.

Yesterday’s portfolios

Thanks to globalization emerging economies exert a significant influence over the developed world, for example, on the cost of oil, copper or grain. Given that developing countries increasingly make and consume most manufactured products as well, it’s a matter of time before they’ll effectively dictate global prices of items, such as cars and smart phones.

The reasons are clear. In terms of purchasing power parity (PPP) developing countries comprise over half of the world’s GDP and rising. They’re home to most of the world’s population and will remain the main source of economic growth. They played a big part in driving down US interest rates and bond yields thanks to their vast foreign exchange reserves.

Emerging markets (as defined by MSCI) collectively account for 82% of the global population, 75% of the land, 63% of the natural resources and 38% of global GDP. “There is no way an investor can have a diversified portfolio after ignoring emerging market economies,” says Kunal Ghosh, a portfolio manager responsible for emerging markets with Allianz Global Investors. Consequently, Ghosh’s “very conservative estimate” is that at least 10% of a retirement portfolio’s equity allocation should be dedicated to emerging market economies. “Given their significance, the allocation should be much higher.”

Yet emerging markets’ growing importance is not mirrored in the portfolios of most pension funds. In fact, they often reflect a bygone era, according to Booth.

Risks in emerging markets are priced in to some extent. This is not the case for developed markets

Fund managers also need to take a broader view of the real risks, says Booth. Most dismiss emerging market assets as too risky. Yet “the risks in emerging markets are well understood and priced in to some extent. This is not the case for developed markets where most investors do not perceive the sovereign risk.”

Additionally, uncertainty and volatility are often confused with risk. While emerging market assets tend to exhibit wilder price swings than their developed equivalents, volatility can be measured and is often due to temporary factors that can be hedged, Booth says.

He is more concerned that the colossal debt and social obligations in the developed world will lead to a rout in developed country bond markets and the US dollar. Given that emerging market countries hold around $11 trillion in developed country liquid assets, Booth’s question is “what happens if emerging market countries withdraw their funds from developed markets.”

Signs of herding

A homogenous investor base, indicating herd mentality, is another worry as foreign buyers of US Treasuries tend to be emerging market central banks. In Booth’s view, this is a danger signal. Once the risks of investing in developed markets are recognized, money will gravitate towards countries with better economic fundamentals and more sustainable debt profiles. Most of them are now in emerging markets, according to Booth.

There is real risk, however, in not fully understanding the country one is invested in. Indeed, this trips up many fund managers. Rather than passively follow emerging market indices investors need to understand the countries they’re invested in. Booth says that through research and monitoring, investors can avoid emerging market bond defaults, for instance.

Nonetheless, the legacy strategies of many institutional investors do open up an interesting long-term arbitrage opportunity, according to Booth. It may well take a decade before institutional investors realize the necessity of diversifying portfolios beyond developed markets – implying that emerging market assets will remain undervalued for many more years to come. This in itself should create an opportunity for long-term outperformance.

Retirement investing: longing for yesterday

With their focus on developed economies, pension funds miss out on emerging market returns, says Jerome Booth

Retirement investing: longing for yesterday

With their focus on developed economies, pension funds miss out on emerging market returns, says Jerome Booth

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