July 11, 2017 / 6:25 PM / 3 days ago

U.S. asset managers under-allocated to emerging markets despite outperformance

6 Min Read

NEW YORK (Reuters) - U.S.-based stock investors may have pumped fresh funds into emerging markets after their recent outperformance, but they remain under-allocated by a key measure, as a combination of "home bias" and lingering concern about volatility have restrained client interest.

While they increased allocation to emerging markets by nearly $52 billion in the first quarter of 2017, U.S.-domiciled active managers still have just 5 percent of assets under management allocated to emerging market equities, data from research firm eVestment shows.

Globally, non-U.S. active funds have about twice the exposure to emerging market stocks, at around 9.94 percent, the eVestment data shows. European-domiciled funds have nearly three times the weighting as their U.S. counterparts at 14.8 percent.

"A lot of our clients, particularly on the private client side are U.S. (dollar)-denominated … they do have a home bias and we reflect that home bias in our portfolios," said Jason Pride, director of investment strategy for Glenmede Trust Company.

Meanwhile, MSCI's all-country world index's weighting to emerging markets has grown to 11.15 percent as of May 2017, from 7 percent in 2006, as more emerging market companies met standards for investable assets.

By being so underweight, American investors have missed big gains since emerging market stocks pulled out of a five-year bear market in early 2016. Since then, MSCI's emerging markets index has surged nearly 48 percent, handily outpacing the S&P 500's 30-percent gain in the same period.

Such caution also reflects emerging markets' long-term volatility. Over the past 18 months of outperformance, emerging markets investors have had to stomach about 35 percent more volatility, Reuters data shows.

Follow the Growth?

But with global economic growth trends favoring the fast-growing asset class, investors will need to move into emerging markets to continue reaching gains above 5 percent in bond and equity portfolios, said Krishna Memani, chief investment officer at OppenheimerFunds. That sentiment was echoed by more than a dozen fund managers interviewed by Reuters who collectively manage hundreds of billions of dollars.

"In a growth-short world, emerging markets are going to be the primary source of growth for the foreseeable future," Memani said. "That is decades."

Emerging economies are expected to grow between 5 percent and 7 percent a year over the next five years and to represent 45 percent of global GDP by 2020, up from 35 percent in 2010, according to data from the Institute of International Finance (IIF). They could represent as much as 60 percent in 15 years. Developed market economies like the United States and Western Europe are expected to expand around 2 percent annually through 2020.

Much of the growth of emerging markets has come from China, which will be more open to investors after MSCI announced in June it would include the country's domestic shares in its emerging markets index starting next year.

While few question the growth trajectory of emerging economies, not all fund managers agree that equates to long-term asset outperformance.

"There is this narrative that you hear a lot that just by divine order EM is going to outperform developed markets because they're growing faster," said Tina Byles Williams, chief executive and chief investment officer of FIS Group. "We don't think that. None of those things are necessarily untrue, but market dynamics change (over time)."

Linda Bakhshian, a multi-asset portfolio manager at Federated Investors Inc, says that for her clients, who are more conservative, the returns are not consistent enough to merit significantly increasing allocation.

"To invest in EM you need to have reliable information," Bakhshian said. "It takes a lot of resources that I could dedicate to other areas that will provide a better return for what I’m looking for."

Not as Sticky

Volatility and long-term underperformance has long led investors to think of EM as a short-term tactical tool to boost returns at the margins rather than a long-term, strategic investment. Indeed, over the past 20 years, MSCI's emerging index's rise of about 80 percent has delivered less than half the gain of the S&P 500's 164 percent.

Emerging markets also have a problem with remaining sticky for foreign investors, according to Emre Tiftik, IIF's deputy director in the capital markets and emerging markets policy department. When developed economies encounter hard times, emerging markets are among the first assets sold.

Money piled out of emerging markets after the global financial crash of 2008, investors further pulled out after the European debt crisis of 2011, and the largest migration from EM came after the Federal Reserve announced in 2013 that it would begin to reduce its bond-buying program.

The debate over the merits of investing in emerging markets is also present between asset managers and clients, many of whom remain skittish about emerging markets.

"We definitely do our part in terms of our research and all the discussions we have on a regular basis with our clients to tell them, ‘Based on our analysis EM is a great place to invest right now,'" said Isabelle Mateos y Lago, BlackRock's chief multi-asset strategist. "But ultimately it’s their decision."

Reporting by Dion Rabouin; Editing by Christian Plumb and Nick Zieminski

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