Emerging markets present opportunities for pension funds

With expected annual GDP growth of 9% to 13% for EM countries over the next three decades—compared to 5% to 7% in developed markets—pension plans have been showing interest in the asset class for some time now, according to Ravi Mantha, an international equity portfolio manager with Pyramis Global Advisors.

“Most pension funds already have an allocation to developing markets through the North American companies that they own,” he says. “For example, Proctor & Gamble saw very strong profit growth from China last year. Nevertheless, there are so many attractively valued emerging market companies that we are obliged to treat them as a separate category.”

Mantha points out that recent research indicates pension plan exposure to explicit emerging market allocation has increased steadily over time. While the average asset allocation to EM is only 3.3%, his data suggests that is bound to increase.

“Of the plans who say they are increasing their EM exposure, 27% are hiring specialist managers, while 5% are adding the ACWI [All Country World Index] to their benchmark,” he says. “However, almost half of plans have asked their managers to allocate tactically—the ‘free lunch’ approach. This allows the manager to simply take advantage of high EM growth, without being measured against a benchmark.”

Risk
Just like a small business, the main issue with EM investing is location, location, location. “Political stability, regulation and the supremacy of the law can be particularly problematic in these countries, and even the most astute stock picker can have his or her portfolio derailed by, for example, an uprising or a decision to nationalize a resource company,” says Mantha. “As investors, we need to appreciate that a country’s politics will always trump any other need—economic development, wealth creation, wellbeing—and that this is particularly true in emerging markets.”

Promoter risk is also an issue, he says, so investors should always look into the quality of the company management. Are they long-term players, or are they using equity investors as a short-term financing tool? Knowing the difference is key.

Manager risk
Mantha explains that some managers make the mistake of judging companies in the same sector by the same rules, regardless of where they are located. He says a quantitative approach is particularly prone to failure in emerging markets, where reliable data can be hard to come by, so to increase your manager’s ability to succeed, you need to be clear in your instructions.

“Recognize that EM are a legitimate opportunity by making an active strategic asset allocation and including them in your plan benchmark,” he says. “Make sure your manager is clear that you want that allocation fully invested. You want to see returns coming from stock selection, not from betting for or against the benchmark. And ask questions about a manager’s decision to underweight certain stocks. You want to be sure managers are basing their decisions on knowledge, not ignorance.”

Mantha believes that in order to succeed, an EM manager needs to have access to global research and focus on stock picking to find opportunities, rather than relying on set measures that have worked in other markets. Simultaneously, the manager must understand the importance of country risk and negative bets. While emerging markets can be intimidating, he feels that with the right manager and a proper understanding of the risks, they can become an important tool in helping pension plans meet their future responsibilities.

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