Emerging market assets still curry favour with institutions and wealthy investors, even as the US Federal Reserve prepares to reverse its extraordinary programme of quantitative easing.

But for some the time could be right for a more discriminatory approach, investment managers say, given how much markets have already rallied.

“From an institutional investor perspective, we are seeing more demand for active management strategies,” Ted Holland, Asia head of UBP Asset Management, said.

“As monetary policies normalise, the correlation among asset classes is coming down, which makes it a much more ripe environment for active managers, as the environment will be more driven by fundamentals rather than pure liquidity or other extraneous factors,” he told AsianInvestor.

It's a point echoed by Adeline Tan, head of wealth advisory at Mercer, who also expects to see greater diversification into alternative asset classes that are less reliant on monetary policy and market beta.

Whether that dents interest in passive emerging markets investing remains to be seen. Assets held in exchange-traded funds generally at the end of August were 35% higher than a year earlier at $4.8 trillion, according to data from London-based research firm ETFGI.

What seems clear is that Fed policy is set to go through a sea-change. The Federal Open Market Committee announced on September 20 that it would begin unwinding its $4.5 trillion balance sheet starting in October, on the back of an improving US economy. The reduction would start with $10 billion a month, gradually rising over the next year to $50 billion a month.

But last week's historic announcement—which was accompanied by no change in US interest rates and hints of another possible hike before year-end—was well telegraphed to markets, which generally remain risk-friendly thanks to a supportive global economic backdrop.

“Appetite for equities has been increasing across institutional markets in Asia Pacific with the exception of Japan,” Marcel de Bruijckere, director of institutional business Asia Pacific at M&G Investments, told AsianInvestor. 

Taking stock

Emerging markets, especially in Asia, have performed strongly this year. The year-to-date return on MSCI AC Asia Pacific Index 20.7%, compared with 13.9% for the MSCI World index. 

For some market experts, it's a good time to take stock. 

“We are cautious and not encouraging investors to jump on this bandwagon given that the markets have run up quite a bit this year,” said James Cheo, an investment strategist at Bank of Singapore who also expects some investors to turn more towards more active strategies to eke out that extra alpha.

But set against that is evidence that money looking for a home in emerging market assets is continuing to build on the sidelines.
 
Bryan Carter, head of emerging market debt at BNP Paribas Asset Management, said: “We are getting many questions from institutional clients asking if it’s too late to add to their emerging market allocations and whether we think the market is too rich now."
 
“Clearly clients are looking for opportunities and the direction of flows is likely to continue one-way,” he added, noting how institutional clients remain underweight in EM debt.

A Bank of America Merrill Lynch report dated July 19 notes that aggregate capital flows into emerging markets in Asia were the best in five years, with debt inflows trumping equity inflows as lower-than-expected inflation continued to surprise investors positively. Debt assets in Korea, India, and Indonesia alone attracted $49 billion year to date, BAML said.

New territory

With US monetary policy entering new territory some market distortions that have resulted from quantitative easing (QE) could be unwound and there could be an increase in volatility, which could yet prompt institutional investors to re-evaluate the risks in their portfolio.

The signalled US rate hike could also be a source of heightened volatility—at least in the short term.

“The December hike was not fully priced in by investors and is likely to be fully priced with some volatility in coming weeks,” pointed out Jean-Louis Nakamura, chief investment officer for Asia Pacific at wealth and asset management group Lombard Odier.

Worth watching will be the US dollar; if the greenback bounces back strongly as quantitative easing is reversed and US rates are jacked higher, then that has the potential to dampen enthusiasm for emerging market assets.

After all, low US interest rates since 2008 have encouraged many emerging market companies to issue dollar-denominated debt and a stronger dollar would make it more expensive to pay back that debt in local currency terms. Foreign investor returns can also be eroded by unfavourable exchange rates.

Even so, as is clear from its signalling, the Fed is proceeding at a snail's pace as it works to unwind the emergency policy stimulus it introduced in the wake of the global financial crisis 10 years ago. 

M&G’s De Bruijckere, cautions against having too many expectations on how markets or investors will behave going forward.

“As the unwinding of QE is unprecedented, there are no lessons to be learned from history,” he said.

For now the outlook for emerging markets assets remains reasonably favourable, notwithstanding the Korea tensions, investment experts say, even as some investors begin to scramble around for more judicious methods of investing.