Can pension schemes take advantage of faster growth rates in emerging markets without investing directly in shares? Tim Sharp investigates
It might seem obvious: if you want to benefit from the fortunes of British companies and British economic growth then you should buy UK-listed shares or bonds. Therefore, if you think that emerging markets – such as Russia, China or India – are more appropriate to your aims, you buy securities of companies or governments in emerging markets.
However, the picture is much more complicated than that. A quarter of UK blue chip companies get more than 30 per cent of their revenues from emerging markets, according to research by investment bank Morgan Stanley. This includes such quintessentially British names as aeroplane engine maker Rolls Royce and conglomerate Unilever, the company behind well-known consumer brands such as PG Tips and Flora.
After rapid increases in recent years, 22 per cent of UK plc’s revenues come from developing economies, Morgan Stanley says. The international colour of the UK stock market also explains why half the FTSE 350 raised the dividend bonuses they paid on shares last year even as the UK remained mired in recession. This raises the possibility for trustees to get exposure to emerging markets by investing in UK companies.
Arjan van Wieren, head of external equities at Mn Services, says that investing in UK equities to give exposure to emerging markets allows investors to benefit from better-established governance practices. “UK-based companies have better corporate governance and use familiar accounting standards”.
He adds that the liquidity – the ease of buying and selling the shares – is greater in developed markets such as the UK. This means that share prices are not as volatile as in emerging markets, where movements can be exaggerated by a lack of available sellers when markets rise and buyers when the market turns down.
A further advantage of investing in domestic stocks is the reduction of ‘currency risk’ (see box). A successful investment made in a local currency could still mean a loss in sterling if the currency in which the investment was made gets devalued. Exchange rate movements can wipe out or amplify gains or losses – adding uncertainty to the investment. There is no way of completely getting away from currency risk, of course, because the revenues of any company that does substantial business overseas will always be affected by such movements, wherever it is based.
In addition to currency risk, there are political risks associated with emerging market investments. Some governments are unstable. Recent events in countries such as Venezuela and Russia show that governments in some states are inclined to intervene in the market directly or through courts even to the extent of forcefully nationalising companies.
There are also disadvantages to getting exposure to emerging markets via stocks listed in the UK, or another developed market. In taking this approach you are not getting a “pure play” in emerging markets – meaning that the businesses you are investing in are only partially involved in emerging markets and will only benefit from some of the advantages that investment there brings.
Emerging markets fund manager Mark Mobius of Franklin Templeton echoes that sentiment. “By directly investing in emerging market equities you obtain full exposure to emerging markets. By investing in developed market companies with emerging market operations, you also get slow moving markets with lower growth potential mixed in.”
For example, van Wieren says: “Vodafone has a lot of emerging markets exposure but it only has part of its activities there. You do not fully benefit from emerging markets.”
There is often a perception that corporate governance standards – the way in which businesses are run – are lower in emerging markets. Mobius disputes that argument: “Corporate governance is always a key concern in all markets, developed and emerging. We have found that developed markets are not superior in corporate governance terms.”
There are other alternatives to equities if trustees want to get involved with emerging market investment. Another way is to invest in so-called debt markets, typically through purchasing government bonds, sometimes referred to as sovereign debt. Corporate bond issuances are relatively rare in emerging markets.
However, unlike gilts or Treasuries (the government bonds of the UK and the US respectively) which are generally considered to be safe havens to retreat to when markets become choppy, emerging market debt is regarded as a ‘risk asset’. When investing in developed market government debt the key consideration is the credit spread – the difference in return between corporate bonds and government bonds.
However, Werner Gey van Pittius, portfolio manager at Investec Asset Management, says that emerging market investing involves analysis of a number of elements including the state of the underlying economy, inflation and currency risk. Investors in emerging market debt also have to decide whether to buy emerging market dollar-denominated debt, which trades off the US Treasury yield curve, or locally denominated debt. Van Pittius says this choice can give the fund manager an extra tool, especially at the moment as Investec forecasts that a number of fast-growing countries are poised for a currency revaluation.
Another avenue for achieving emerging market exposure is through sectors such as commodities, which are linked to demand from emerging markets. With commodities, the investor has a choice of whether to invest directly in emerging markets, for instance via Brazilian oil producer Petrobas, or through companies based elsewhere with interests in emerging markets. There are plenty of UK-based companies with substantial earnings from emerging markets such as oil and gas operators Cairn Energy and Tullow Oil or miners including Lonmin and Antofagasta.
There is also the option of buying into an exchange traded fund to get direct exposure to the asset class. Ultimately, the choice of whether to get involved with emerging markets directly or via UK markets is down to the profile of the pension scheme. If the trustees can accept the additional risk, directly investing in emerging markets should provide a worthwhile level of additional compensation. If not, decent returns are still available in other ways.
CAN ‘CURRENCY RISK’ WORK FOR PENSION SCHEMES?
Investing in emerging markets exposes UK pension schemes to ‘currency risk’, where the value of the investment can be eaten away if sterling increases in value against the currency it is denominated in. However schemes can protect, or hedge, themselves against currency risks. Currencies can also be traded to offset risks posed by emerging market investment.
There are strong relationships between the economic performance of countries and the value of certain currencies. One recent example is of the Chinese authorities restricting the supply of money to cool down its economy, which had a negative effect on all emerging market ‘commodity’ currencies - countries where exports are dominated by commodities, usually destined for China. Therefore, such currencies are said to be inversely correlated to the Chinese yuan (ie when the yuan does well, they tend to do badly and vice versa) and can be used to protect against the risk of a crash in the value of Chinese investments.
Such relationships are not always straightforward and can only be handled by professionals. “We saw quite a pronounced US dollar bounce during December and January, primarily linked to growth concerns in the US and later, the European sovereign risk issue,” notes George Tchetvertakov, currency expert at Alpari. It seems counter-intuitive that the US dollar increases on bad news from the US. It does so because such news is a bad signal for the world, prompting investors to run to safe havens “and the biggest safe haven is the US. “The dollar fell for the duration of 2009 on the back of recovery expectations,” said Tchetvertakov. “Now, the dollar is strengthening as recovery expectations, to an extent, are failing.”
Such counter-intuitive stories can be useful to investors that are experienced enough to recognise them, and are not permanent. The US dollar can only sustainably strengthen when its economy rebounds enough for interest rates to be raised. “Yields are probably the most important factor behind currencies,” adds Tchetvertakov.