Set to Soar

Set to Soar
There’s opportunity in Emerging Markets, but there are also risks.

By Ravi Mantha Portfolio Manager, International Equities Pyramis Global Advisors, a Fidelity Investments Company.

The emerging markets opportunity
Over the next 20 to 30 years, nominal GDP growth in emerging markets countries (or “EM”) is expected to reach 9 to 13%, compared to 5 to 7% in developed markets.

Assuming corporate profits are a constant share of GDP, this higher growth could translate directly to higher stock market returns -- growth that can help fund Western pension plans.

Many plan sponsors have recognized the opportunity in emerging markets equity. Recent survey findings show that 17% of plans have explicit emerging market allocation, a number that has increased steadily over time. While the average asset allocation to EM is only 3.3%, that is bound to increase. Already 27% of plans are indicating that they will increase their exposure by the end of 2009.

Almost half of these plans are asking their managers to allocate tactically. This is the “free lunch” approach, which allows the manager to simply take advantage of high EM growth, without being measured against a benchmark. Other plans have formally added EM to the plan benchmark and indexed it. Overall, this is a better approach, although results may not reach full potential because of the inefficiency of these markets. Ideally, plans should add EM to the plan benchmark and actively manage it.

Where’s the risk?
Is there a downside? The biggest risk specific to EM investing is the country allocation. Political stability, regulation and the supremacy of the law can be particularly problematic in these countries, and even the most astute stock picker can have his or her portfolio derailed by, for example, an uprising in Tibet or a decision to nationalize a resource company.

The second most important issue is promoter risk: what is the quality of the company management? Are they long- term players or are they using equity investors as a short-term financing tool?

In EM, manager risk is also significant
The difference between success and failure is much higher than in developed markets. Approaches that may pass muster in developed markets can prove disastrous in emerging markets. Having a single point of view or relying on a few key people to make overall projections can lead to major errors.

Some managers make the mistake of judging companies in the same sector by the same rules, regardless of where they are located. A quantitative approach is particularly prone to failure in emerging markets, where reliable data can be hard to come by.

It is also particularly important to avoid negative bets based on ignorance. In emerging markets, what you don’t own is often what kills you from a relative performance standpoint.

How can you recognize a good emerging markets manager?
In order to succeed, an EM manager needs to have access to global research and focus on stock picking to find opportunities, rather than relying on set measures that have worked in other markets. At the same time, the manager must understand the importance of country risk and negative bets.

Pyramis recognizes that emerging markets can be intimidating. But with the right manager and a proper understanding of the risks, we believe it can become an important tool in helping pension plans meet their future responsibilities.