Emerging markets shift gears - Perspectives from The Economist … · 2015-10-22 · Emerging...

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Global challenges in asset managementEmerging markets shift gearsA report from The Economist Intelligence Unit

1© The Economist Intelligence Unit Limited 2014

Global challenges in asset managementEmerging markets shift gears

Contents

Introduction 3

From yield to maturity: Development of local currency debt markets 4

Emerging markets: Alpha, beta or bust? 8

Conclusion 11

2 © The Economist Intelligence Unit Limited 2014


Global challenges in asset management: Emerging markets shift gears is based on two webinar events held by The Economist this year: one held in Kuala Lumpur on September 3, 2014 and another held in Dubai on October 27, 2014. The webinar events and this report are sponsored by Malaysia’s Islamic Finance Marketplace. The focus of the event in Kuala Lumpur was local currency debt markets—their relative maturity, market trends and obstacles to further development. The event in Dubai looked at investment strategies in emerging markets and the relative advantages of active and passive approaches.

The aim of both events, which were moderated by a senior editor from The Economist Intelligence Unit, was to bring together expert panelists to engage each other in dialogue about how emerging market investing has become a challenge to asset managers. The events also uniquely sought to include Islamic perspectives on the issues in focus for a more diverse and robust discussion.

About the report

About the sponsorSince its introduction more than 30 years ago, Islamic fi nance in Malaysia has developed into a comprehensive and sophisticated Islamic fi nance marketplace. Malaysia’s Islamic fi nance marketplace is served by the Malaysia International Islamic Financial Centre (MIFC) Community, founded on the launch of the MIFC initiative in 2006. The MIFC Community is a network of the country’s fi nancial sector regulators, government ministries and agencies, industry players from the Islamic banking, takaful, re-takaful and Islamic capital market industries, human capital development institutions as well as professional ancillary services companies ranging from legal fi rms and Shariah advisories to tax and audit fi rms and research companies. For more information on Malaysia’s Islamic fi nance marketplace, please visit www.mifc.com.



One would think that with the S&P 500 in a bull market and bond yields still generally very low that asset managers would be struggling to come up with complaints. Such is not the case.

Today, the global asset management industry faces multiple challenges, including navigating central bank policy divergences, fi nding sustainable sources of risk-adjusted returns and managing exposures to myriad risks, including those stemming from regulatory actions and political events. Mohamed El-Erian, chief economic adviser to Allianz and chairman of US President Barack Obama’s Global Development Council, recently noted the fund management industry has enjoyed a wave of central bank liquidity that broadly boosted asset prices, but needs to consider life without such extraordinary support. “The longer the wave persists, the greater the challenges it poses for the industry in future. Asset managers would be well advised to prepare now rather than get caught out when the wave ultimately breaks,” Mr El-Erian wrote in commentary published in September.1

Investors in emerging markets (EM) certainly anticipated the wave breaking last year.

Expectations that the Federal Reserve would wind down its quantitative easing programme led to a broad sell-off in EM assets. However, US bond yields have remained remarkably low, supporting EM fi xed income markets this year.

Underlying fundamentals are diffi cult to read, while recent economic data from China and Brazil have not been particularly promising. Credit growth in China, which has been a key driver of economic activity since the fi nancial crisis, dropped in July, the lowest in more than four years before rebounding somewhat in August. Brazil slipped into recession in the fi rst half of the year. Argentina’s recent debt default, the ongoing standoff in Ukraine and new political leadership in India and Indonesia altogether paint a complicated picture.

This report is focused on the challenges of EM investing. The supposition is that it is no longer prudent to treat EM as a single bloc. Growth has shifted to a lower gear in large EM economies, but the impact on investment opportunities is not uniform. Economic fundamentals in these markets appear to have become more differentiated and thus investors need to adapt.

Introduction1

1 Financial Times, “Post-QE wave to break over fund managers”, 8 Sept 2014.



For a playback of the webinar, click here

Panel discussion participants:• Ahmad Najib Nazlan, executive director, Amundi Islamic Malaysia

• Badlisyah Abdul Ghani, chief executive offi cer, CIMB Islamic Bank Berhad

• Donald Amstad, director, Aberdeen Asset Management

• Mohd Daud Bakar, founder and group chairman, Amanie Advisors

• Kevin Plumberg, senior editor, Economist Intelligence Unit

For many investors, a question mark has hung over the local currency bond markets since May 2013 when fears of Federal Reserve tapering triggered widespread volatility. EM local currency bond funds have suffered net outfl ows of US$4bn so far this year, in contrast to EM hard currency bond funds, which have absorbed net infl ows of US$16.5bn.2

Are local currency bond markets mature enough to deal with such an outfl ow of foreign capital? Are the pools of liquidity deep enough to handle sudden reversals in the movement of capital and do these markets have a variety of issuers to attract an equally diverse investor base? To these questions, the panellists generally agreed that local bond markets in emerging economies have

JPMorgan GBI-EM index, 2011-2014

Source: JPMorgan.

Recovery mode?

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2 Data as of Nov. 6, 2014. JPMorgan, EM fixed income flows weekly, Nov. 6, 2014.

From yield to maturity: Development of local currency debt markets2

http://www.pvwebmedia.com/economistevents-globalchallenges/index.php?controller=live#general_load



matured signifi cantly and while last year’s sell-off was painful, the fact that markets have rebounded relatively quickly suggest resilience to large outfl ows.

“In terms of the way the debt markets have matured, we have a pretty much full yield curve,” said Donald Amstad, director of business development at Aberdeen Asset Management. Unlike a decade ago, there are a dozen markets

where an investor can buy bonds for any duration from 1 year to 10 years. It is an important development because foreign investors can adjust their duration, or exposure to interest rate changes, by shifting between maturities and they can aim for higher returns through more complex trades that may require buying bonds from one end of the yield curve while selling bonds on the opposite end of the curve.

EM local currency debt market at a glance• Outstanding debt reached US$9.1trn, or 87 percent of total EM debt, as of December 2012.

• Local banks dominate holdings of the asset class, but domestic insurance and pension funds have been increasing participation in the market.

• Foreign investors on average account for 27 percent of local debt demand.

• Local currency bond funds have seen net capital outfl ows of US$4bn in 2014, as of Nov. 6.

VARIETY OF INVESTORSCiting one of the ways that local markets have matured, Ahmad Najib Nazlan, executive director at Amundi Islamic Malaysia, said that there are today a “myriad of investors” including local pension funds, statutory bodies and central banks that make it attractive for issuers to tap capital markets for funding.

Badlisyah Abdul Ghani, chief executive offi cer of CIMB Islamic Bank Berhad, said that the market in Malaysia is deep enough to ensure adequate demand for ringgit-denominated bonds. The depth of Malaysia’s bond market has two implications, he said. First, there is little need for Malaysian companies to tap foreign bond markets unless they require foreign currency for their businesses. Second, some foreign issuers have become keen on tapping the local investor base in Malaysia for funding and swapping the proceeds into other currencies.

Investors in Malaysia also have a strong appetite for sukuk issues, another key component of

the local debt market. Often referred to as the Islamic equivalent of a bond, sukuk is a structure in Islamic fi nance that grants investors a share of an asset, which the investor rents back to the issuer for a rental fee. This structure is permitted by Islamic law, as opposed to traditional bonds, which involve the charging or paying of interest. The continuing strong appetite for sukuk among Malaysian investors could encourage a greater number of Malaysian companies to tap this market, Mr Ghani said.

A NEED FOR BETTER TOOLSMalaysia has the largest local currency sovereign debt market in the ASEAN region. But emerging markets as a whole contain many different levels of maturity.

Moreover, many local bond markets still need better tools to provide investors with more fl exibility. Mr Nazlan said: “There are aspects of these markets that have to be developed further, in terms of risk management tools, the interest rate swap market, the currency swap markets.”



The fact is that by defi nition local currency bond markets have inherent currency risk, which make them a riskier proposition than bonds denominated in US dollars or euros. This may deter foreign investors with strict constraints from participating in local currency debt markets. Governments in some cases may want to offer incentives such as the provision of swap arrangements for foreign investors looking to invest in currencies other than hard currencies, Mohd Daud Bakar, founder and group chairman of Amanie Advisors, said. He added that advanced swap programmes are needed to allow foreign investors to take a longer term view of a market for without them, it can be challenging for them to invest. “We have to facilitate the risk appetite of foreign investors,” he said.

CORPORATES COME TO MARKETIn another sign of the increasing maturity of the local debt markets, EM companies are expected to increase their home currency bond issuance, offering investors a much greater array of choices. This is where panellists believe the next phase of development for the industry lies. Mr Amstad said that corporate bonds currently tend to be relatively illiquid and expensively priced.

Outstanding local currency corporate bonds grew over 10 percent in USD terms in 2012 to US$6.8trn, though the bonds are not heavily traded and pricing not always so transparent.3

However, companies should increasingly be able to get longer-term fi nancing from the bond markets domestically rather than having to rely on banks. “We are going to see more corporates, including some of the larger SMEs—who previously only tapped the banking sector—coming to tap the bond market for fi nancing,” Mr Ghani said.

The growth of local currency corporate bond markets will also bring new risks. For example,

new EM corporate bond issues may not be rated by one of the main credit rating agencies on which global investors rely. Unrated bonds can be cheaper than rated ones and thus hold the potential for investors to fi nd value. However, picking and choosing between unrated bonds requires capabilities to conduct in-depth credit analysis and awareness of the differences between the advanced and EM landscapes. For example, in EM, there is signifi cantly less clarity about the rights of bond holders in the event of a bankruptcy of the bond issuer compared with the US market.

In Islamic fi nance, non-sovereign sukuk issues are also expected to grow, as a greater variety of “borrowers” become comfortable with the non-traditional structure. For established sukuk funds and bond funds with constraints that would allow allocation to sukuk, the potential for added portfolio diversifi cation is likely attractive, particularly after the UK’s fi rst sovereign sukuk issuance in June and Goldman Sachs’ announced plans to issue sukuk. Standard & Poor’s Ratings Services forecasts issuance of corporate and infrastructure sukuk in the Gulf Cooperation Council (GCC) and Malaysia to increase over the next few years, owing to growing refi nancing needs of companies and as more organisations establish themselves as issuers of sukuk.

GLOBAL FACTORS IN LOCAL MARKETSThe near-term outlook for local currency bond markets may hinge on factors that are beyond the control of local governments. The US Federal Reserve is widely expected to raise its benchmark interest rate in 2015, and the European Central Bank (ECB), which is struggling to avoid defl ation, could turn to full-blown quantitative easing (QE).

The Federal Reserve’s asset buying programme ended in October and the EIU predicts the benchmark Fed funds rate will rise during the

3 Ashmore, Growing opportunities in emerging market corporate bonds, March 2014.

We are going to see more corporates, including some of the larger SMEs—who previously only tapped the banking sector—coming to tap the bond market.

Badlisyah Abdul Ghani, CIMB Islamic



second half of 2015. Rising interest rates risk triggering outfl ows from local currency bonds, as the gap between local interest rates and US rates shrinks.

ECB action could actually provide a countervailing force if it unleashes QE of its own, following in the footsteps of the central banks of Japan, the UK and the US. Such action could add signifi cant liquidity to global markets.

A SEISMIC EVENTIn Asia, the panellists expect two events will mainly shape the long-term outlook on local currency EM bonds. The fi rst is the opening of the capital account and capital markets in China — a “seismic event” for the global fi nancial system, said Mr Amstad, who compared its importance with the launch of the euro. The size of China’s economy means its deeper integration into the global fi nancial system will signifi cantly change global capital fl ows.

Considering that China is currently not a constituent of various benchmark bond indices, the opening of the country’s capital account will have a major bearing as China’s weight in indices is going to be “extraordinary”, according to Mr Amstad. The domestic bond market in China today, for instance, is worth US$3.5trn. To put

that in perspective, the JPMorgan Emerging Market Bond Index, the GBI-EM and the Corporate Emerging Markets Bond Index put together had a combined market cap of US$2.8trn as of the end of 2013.

The second event that could shape the outlook for local currency bonds is the formation of the ASEAN Economic Community (AEC), which is offi cially scheduled to come into being in 2015. Though the timetable is uncertain, the AEC is expected to have a profound impact on ASEAN’s local bond markets. Mr Nazlan said closer integration between economies and markets in South-east Asia should theoretically result in greater transparency in bond pricing and freer fl ow of capital across borders.

Integrated local debt markets in ASEAN would be an exception rather than the rule. The panellists agreed that while local bond markets have generally matured signifi cantly over the past several years, they remain fragmented on the basis of their different market structures. These markets remain highly idiosyncratic, but for active investors that may be a source of potential alpha—or above-benchmark returns. Indeed, the growing maturity of local bond markets may require investors to reconsider which strategies are the most effective.

The opening of China’s capital account and capital markets will be a “seismic event” for the global fi nancial system.

Donald Amstad, Aberdeen Asset Management



Market volatility in late October, following Dilma Rousseff’s narrow victory in Brazil’s presidential election, was a good example of one of the main challenges of investing in EM. Ms Rousseff’s win – interpreted by investors as detrimental to the broader economy - immediately sent the markets in a spin. Brazil’s real fell 3.1 percent against the US dollar in a single day to its lowest level since May 2005 and the Sao Paolo stock market slumped 6 percent. What is the best approach to navigating these markets: actively managing a portfolio or using a passive approach?

Brazil is also a good example of an EM economy seeing growth slow considerably. That only has made the question of what investment strategy to use even more pertinent. Active investors often say that their approach makes a lot of sense in EM because of the ineffi ciencies in markets that can be exploited by a skilled investor. Andrew Goldberg, global market strategist with JPMorgan, said developing economies are

not a bloc, and “it’s important to drill down, differentiate and know, for example, who’s more susceptible to rising rates in the US versus who’s more insulated”. Isolating the impact of growth in the US, Europe and Japan on EM, for example, shows that individual EM countries are affected differently, depending on whether they are commodity exporters or manufacturing economies.

DIFFERENTIATORSDifferentiation is certainly part of Mark Mobius’ approach to pursuing EM opportunities. Mr Mobius, executive chairman of Templeton Emerging Markets Group, said the markets in which he has the highest conviction are China, India and several frontier economies. Drilling down further, Mr Mobius is focused on the banking sector as a way to access the growing wealth of consumers. He also is focused on the leisure and healthcare industries.

Exclusive one-on-one interview:• Mark Mobius, executive chairman, Templeton Emerging Markets Group

Panel discussion participants:• Wan Kamaruzaman Wan Ahmad, chief executive offi cer, Retirement Fund Incorporated (KWAP), Malaysia

• Andrew Goldberg, global market strategist and head of the market insights strategy team in Europe, JPMorgan

• Gaurav Mallik, portfolio strategist, active emerging markets investment team, State Street Global Advisors

• Andreas Zingg, director, head of iShares Middle East & Africa, BlackRock

• Kevin Plumberg, senior editor, Economist Intelligence Unit

For a playback of the webinar, click here

Emerging markets: Alpha, beta or bust?3

http://live.wavecast.co/globalchallenges/live-feed/



An advantage of stock pickers is that they can potentially root out opportunities that others overlook. In this respect, frontier markets, including those in Africa and the Middle East, are where Mr Mobius has been paying more attention lately. Yet why couldn’t an investor seeking more exposure to frontier markets, which are essentially aspiring emerging markets, buy exchange-traded funds (ETFs) for a much lower cost than buying an actively managed fund? That question summed up a dilemma in the asset management industry today, but it was also an area where Mr Mobius recommended caution, particularly when it came to frontier markets.

As frontier market ETFs grow in size, it will be increasingly diffi cult for them to replicate an underlying index of relatively illiquid markets without creating an unwanted market impact. “Going into frontiers with ETFs would be a dicey and risky adventure,” Mr Mobius said.

PASSIVE AGGRESSIVE…Regardless of the debate over frontier market ETFs, passive strategies are being increasingly deployed by investors to get wider exposure to the macro fundamentals of EM economies. Proponents say instruments such as ETFs enable investors to have a greater diversity of exposures across EM at a lower cost than actively managed funds.

Furthermore, passive investing is not just about putting one’s money in an index or ETF and waiting for it to rise. So-called smart beta investing involves creating tailored indexes that are not based on the traditional criterion of market capitalisation. Andreas Zingg, head of iShares Middle East & Africa with BlackRock, said smart beta strategies are a way to manage – and even benefi t from – the rise in volatility that EM stocks have seen in the past year. A minimum volatility index is designed to outperform broader

markets in adverse conditions. Mr Zingg pointed out that in the past three years the iShares MSCI EM Minimum Volatility Index outperformed its parent index by more than 15 percent.

...OR HYPER-ACTIVE?On the fl ipside, active investment strategies, although more costly, enable investors to exploit opportunities that arise as a result of market imbalances and differentiated economic growth rates across EM. The belief of the active investor is that the increase in price volatility in EM bonds and equities as well as the divergent economic growth trends are ideal conditions for a skilled manager to sift through assets being unloaded in a hurry to fi nd interesting opportunities.

Gaurav Mallik, portfolio strategist at State Street Global Advisors, said that even in developing economies that are witnessing healthy growth rates and sound fundamentals, it is important to identify the drivers. In India, for instance, most of the growth has come from consumer-oriented sectors, so a recovery may eventually spread to the industrial and fi nancial sectors. An active manager would thus drill down in these sectors and fi lter opportunities.

In terms of how investors have been accessing active opportunities, Mr Mallik said regional, country-specifi c and small-cap funds have been popular, with the latter being a more recent focus.

Mr Zingg from BlackRock added that investors have been increasingly interested in regional and single country EM ETFs as well. However, timing bets on the market by using country-focused ETFs is diffi cult to get right. Active stock selection can face the same challenges of market timing, but allows investors to manage the impact of currency fl uctuations on international investments. EM currencies have been a signifi cant source of market volatility in the past year.

Going into frontiers with ETFs would be a dicey and risky adventure.

Mark Mobius, Templeton Emerging Markets Group



THE RIGHT MIX?Ultimately, the choice of whether to use an active or passive investment strategy in EM is based not only on the strength of the approach but also on an investor’s objectives. Achieving investment targets may involve a mix of alpha and beta strategies based on their tolerance of risk, such as multi-asset strategies. While such a mixed strategy could result in diluted alpha as well as higher costs of investing, the potential for portfolio diversifi cation is an advantage.

Mr Goldberg from JPMorgan said a recent example that has been popular with investors is combining EM debt and EM equity investment strategies in pursuit of income.

SHARIAH CHOICESWan Kamaruzaman Wan Ahmad, chiefexecutive of Retirement Fund Incorporated (KWAP), Malaysia, says the US$33bn fund is currently invested entirely based on“socially responsible investing” (SRI) principles. To this end, Mr Wan added that the fund would be looking

to hire external managers to further develop capabilities when it comes to environmental, social and governance portfolios, otherwise known as ESG investments.

The fund has recently started investing more in shariah compliant instruments, too. Shariah-compliant strategies are sometimes included as a part of the wider universe of socially responsible investments, because Islamic fi nance bars dealing with businesses that engage in sinful or irresponsible activities – similar to the focus of SRI portfolios. How those are defi ned of course are up for interpretation.

Could KWAP cut costs by investing more in passive strategies? Possibly, but creating more ETFs that track Islamic indexes is challenging because of a lack of global or regional standards, said Mr Zingg. “It is hard to identify standards. That makes it diffi cult for us because when we have product ideas, we share it very early with clients and we need strong and clear feedback to push the button and to launch a product,” he added.

Currencies vs the US dollar, September 1st, 2013=100

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Our webinar discussions revealed three key challenges that investors face today when it comes to global EMs: lower growth in some developing economies, poor performance and divergent monetary policies in advanced economies.

Global economic woes are not expected to abate anytime soon, and the EIU has consistently lowered its 2014 and 2015 growth forecasts. We estimate the global economy will grow 3.1 percent in 2014, lower than the 3.6 percent forecast in January. EM economies are expected to post GDP growth of 4.5 percent in 2014, delivering the smallest premium over developed economies since 2000. If they haven’t already, asset managers will likely have to become accustomed to slower growth and increased fragmentation in EM.

Yet, slower economic growth has not had an impact on the development of local debt markets. While local bond markets witnessed a large sell-off last year, they saw a quick rebound, suggesting growing maturity and resilience. EM corporate bond issuance has also continued to grow and offer investors a wider variety of investments.

The growing prominence of Islamic fi nance is promising too, with increased demand for shariah-compliant investment instruments from traditional investors as well. Sukuk issuance, both sovereign and non-sovereign, has expanded, providing more portfolio diversifi cation opportunities to a wider group of investors.

Conclusion4The question of which investment strategy to use in EM will continue to be a vital one, though investment objectives should ultimately be the deciding factor in whether to use an active or passive approach. Asking which is better, an active or passive approach when it comes to EM investing, is a false dilemma and really depends on what investors are aiming to achieve. For example, Mr Wan from the Malaysian public pension fund KWAP says that his fund would likely outsource active strategies that do not use benchmarks while bringing back some benchmark-driven mandates in-house to manage costs.

In addition, many asset managers are exploring blended strategies as a way to meet their clients’ targets.

An area that could have a signifi cant bearing on EM prospects is structural reforms to manage economies more effi ciently. Today’s slower growth may act as a catalyst for these policy-led reforms, perhaps leading to better infrastructure in India, more consumption in China and more competitive manufacturing in Brazil and Russia.

Developing economies account for more than 35 percent of the global GDP, but only 20 percent of global equity and 12 percent of global bond markets, suggesting substantial scope for growth. But investors’ and asset managers’ adaptability and fl exibility will likely be the largest determinants of EM prospects.

While every effort has been taken to verify the accuracy of this information, The Economist Intelligence Unit Ltd. cannot accept any responsibility or liability for reliance by any person on this report or any of the information, opinions or conclusions set out in this report.

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Emerging markets shift gears - Perspectives from The Economist … · 2015-10-22 · Emerging...

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