By Martyn Hole
Many investors are aware that it is important to gain access to emerging markets as the world’s engine for growth. There is recognition of better economic fundamentals within many emerging markets, with less external debt and more potential for growth than some developed economies. Indeed, for some defined benefit schemes, emerging markets has long been regarded as a core asset class.
However, most defined contribution (DC) schemes have little or no emerging market exposure, as the risk of high volatility makes it unsuitable for many investors. While volatility in emerging markets has generally declined in recent years, it remains well above that of developed markets, averaging around 25% over the long term, compared to approximately 17% for most developed markets. [source: MSCI] There are still many risks of investing in emerging markets, including currency controls, exchange rate fluctuations, financial infrastructure – for example, less developed exchange and settlement mechanics – as well as corporate and political risks.
There are, however, ways to gain access to emerging markets while managing volatility. As recently as 1995, the only significant emerging market asset classes were large-cap equities and sovereign dollar bonds. Investing was a rather singular high-risk, high-return decision. Today, emerging markets have matured, and there is a range of asset classes offering different risk and return profiles – local currency bonds, corporate bonds, inflation- linked sovereign debt, small cap companies and ‘frontier markets’ such as Saudi Arabia. Investors can diversify and manage volatility and risk by investing across the full emerging market universe. For example in 2011, when emerging market equities fell 20% (source: MSCI), emerging market local currency debt (source: JPM GBI-EM) declined 2%. In particular, investing security by security can optimise risk and return. A mini case study illustrates how this approach can work. One of the most exciting stories to come from Brazil has been the development of the sub salt fields lying off the Brazilian coast. Some believe that these sub salt fields may contain as much oil as all of Iraq. The obvious way to access this opportunity is investing in one of Brazil’s main oil and gas exploration and production companies.
However, such companies face a number of challenges, including:
• Technical risks – the oil lies 7,000 kilometres below the surface, the very frontier of what is possible
• Financial risks – costs of exploration may be as high as $500bn over 20 years.
• Political risk – in a lower growth environment the government is adopting a more interventionist stance to fuel growth.
There are less risky ways to access the opportunity, for example by looking at suppliers to the main exploration companies – the companies that lease out the oil rigs used, companies that create the steel tubes used in the exploration process. Some of these companies only issue bonds; others only issue equity. So a multi- asset approach is able to diversify and manage risk in a way that a single asset class strategy cannot.
Replicating these types of decisions across an entire portfolio can give exposure to the growth opportunities in emerging markets with less volatility. We believe that it is important for DC investors to consider a multi asset approach to emerging markets to grow their assets while at the same time managing volatility.
Martyn Hole is an investment specialist at Capital Group
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