Institutional investors look to emerging markets in the hunt for returns

Emerging Markets

The search for alpha is expected to lead to a long-term shift to higher emerging markets allocations, both in equity and fixed income, according to a survey of institutional investors by Vontobel.

Vontobel surveyed 300 institutional investors and discretionary wealth managers globally in Europe, North America and Asia-Pacific in the second quarter of 2020.

A minority expected to make larger allocations towards EM over the next 12 months, but bigger shifts are expected to take place over the longer term.

European investors said they believe alpha opportunities are easier to come by in emerging markets compared to developed markets, with 41 per cent of European investors who plan to increase emerging markets exposure calling it one of their top two most important drivers. In North America, a lower figure of 34 per cent cited that belief as a cause for higher EM allocations, and just 18 per cent agreed in Asia.

Another top-two key driver among European respondents, was the potential for enhanced returns versus developed markets as one of the top two key drivers, cited by 40 per cent.

While many investors are attracted by the opportunities in emerging markets, the coronavirus pandemic has scuppered plans with over a third (35 per cent) of European respondents saying they expect to reduce emerging markets allocation for the next 12 months, and 29 per cent with no plans to change their level of allocation in this time. 

APAC investors were more optimistic, with just 23 per cent planning to reduce emerging markets allocation, as many APAC investors have seen developing economies in their region such as China, faring much better than some developed markets.

“The virus could actually lead to increased allocations, because it challenges the conventional view that what is a problem in developed markets is a crisis in the emerging world,” says Vontobel’s Matthew Benkendorf. “Covid-19 didn't cause disproportionately more damage in some emerging markets.”

The survey also addressed a question that has preoccupied many investors and that is how they should deal with the rise of China, which now accounts for a significant proportion of emerging market index weightings.

Just 37 per cent of European investors believe that China is now too big a market to be accommodated in a broad exposure to emerging markets where investors should consider it as a standalone asset class or market. This is significantly lower than sentiment expressed in the Asia Pacific region, where over half (53 per cent) hold this opinion.

Andrew Cormie of Eastspring Investments, believes that the breadth of the Chinese equities market is often overlooked – and that it includes a very wide range of privately owned enterprises, which could offer opportunities for diversification. “We encourage people to take a ‘whole of China’ approach rather than just getting an A-share manager,” he says. “If you're going to give someone a China mandate, give them the ability to invest across the whole of China.”

The active versus passive management debate continues to be a fundamental question for investors as they look to put their emerging market ambitions into practice.

Forty-five per cent of European investors will employ mostly or entirely active strategies as they increase exposure to EM equities, a significantly higher rate than that for passive (12 per cent).

Asked why that is, many investors point to elevated emerging market volatility as a reason to choose active funds, adding that it is much more difficult to use risk mitigation strategies when buying an index.

“In emerging markets, where you have a generally less-developed set of economies and companies, you have an index construct that is lopsided in many ways,” says Vontobel’s Matthew Benkendorf. “The index is a less optimal way to buy the really great companies that will compound long-term wealth with the lowest relative risk.”

In terms of asset class, many European investors are looking beyond equities and fixed income and are more inclined to diversify their EM portfolio, as 42 per cent of them plan to increase allocations in other assets such as infrastructure and real estate in the next three to five years. Their North American and Asia-Pacific counterparts, however, are more inclined to allocate to these assets, with 52 per cent and 67 per cent planning to do so respectively.

In fixed income, meanwhile, investors simply have no choice but to look further afield for return opportunities, according to Luc D’hooge, Vontobel’s head of Emerging Markets Bonds. “For some time, we have had low yields in developed world markets such as the Swiss franc and the euro, but even in the US there’s now not much yield left,” he says. “That should push investors toward emerging markets.”