Increasing numbers of US state and private pension funds are issuing RFPs for global emerging market debt mandates, underlining what many see as a long-overdue departure from traditional asset allocation.
Numerous large American state pension funds have issued such mandates recently, including the Public Employees Retirement System (PERS) in both Ohio and Iowa, the Louisiana Teachers’ Retirement System and the Massachusetts Pension Reserves Investment Management Board.
Add at least four US corporate pension funds currently engaged in EM manager searches, say sources, and the picture becomes clear. US institutions that have been significantly underweight non-US asset exposure as a rule are finally dipping their toes in the water, albeit gradually.
“They are coming around to the realisation that they have been overly exposed to US financial instruments and that it is not representative of global GDP contribution or where the growth of global GDP is going to come from,” says Brian Baker, CEO of Pimco Asia.
Kevin Daly, EM debt portfolio manager for Aberdeen Asset Management based in London, notes that US pension fund managers have been behind the curve in terms of EM exposure.
The driving force behind this change in mindset is understood to be the extremely low yields and low growth trajectories of developed markets and the likelihood that central banks will seek to reflate their way out of their debt dynamics.
Another significant factor is likely to be the fact that consultants, whose opinions are heavily relied upon by US state pension funds especially, have themselves shifted their asset allocation views towards increased EM exposure.
“The fundamental arguments of why to increase exposure to emerging markets are there, now US pension fund managers are trying to make that happen,” Daly tells AsianInvestor.
“These are the types of assets you want to see coming in to emerging markets, to replace the hot-money guys in it for the short term. Institutional investors are clearly putting more into emerging markets and that to me is a multi-year trade.”
He blames the volatility of fund flows to and from emerging markets on retail investors, and argues it is a behavioural as much as a liquidity issue.
“When something is blowing up in one part of the world, historically investors have sought to take money back out and retreat to the comfort of treasuries and cash.
“But over time that behaviour will change. Emerging markets recover quickly from outflows these days, and investors will quickly realise that. Last year we saw the retail guys take their money off the table, but our institutional investors didn’t.”
Daly notes that while around $40 billion exited EM equities in 2011, already more than $20 billion has flowed back in, above all into exchange-traded funds.
But he stresses: “Institutions and providers of investment capital globally are adding to positions year-on-year. They are not the ones driving these flows. The big state pension funds in the US, for example, are eager to see their exposure to emerging markets increase.”
Daly believes markets will be tested again this year, given looming elections in France and Greece among others, but points to the return of some pricing normality in eurozone debt markets following the introduction of the European Central Bank’s Long-Term Refinancing Operation (LTRO), which enables banks to borrow for three years at a 1% interest rate.
He suspects that the real test of market sentiment towards EM investment will not be a eurozone blow-up, a popular uprising in Greece or even a slowdown in Chinese growth. “It is going to be when the US Federal Reserve starts hiking rates again, probably not until 2014,” he surmises.
“Investors are likely to suffer some losses in emerging market debt over the short term when the Fed starts hiking, so one would expect to see some outflows around that period. But because the Fed keeps pushing the window out more and more, you can definitely see more robust inflows into emerging markets in the coming few years.”
The appeal of emerging market debt, he notes, is two-fold: improving credit with further ratings upgrades in the pipeline, along with higher yields.
As a house Aberdeen is overweight Latin America and holds a constructive view on Mexico – which Daly describes as a deep, liquid market where the central bank has historically not intervened in the FX market – and parts of emerging Europe including Poland.
However, it is underweight Asia, notably Indonesia and Malaysia. “Asian rates are not that compelling, and with expectation that China will slow appreciation this year, the Asia FX story is not that exciting,” adds Daly, who excludes the Malaysian ringgit, where he does see value.
Aberdeen handles around $14 billion in EM debt (compared with $90 billion in EM equity), of which $8 billion is managed by its growing EM debt team out of London and the remaining $6 billion out of Singapore.
The firm has added two staff in London to focus on EM corporate debt, which Daly describes as the future of the asset class and destined to rival the US high-yield market before long.