Last year, I wrote about emerging market equities and whether their time had finally come. Should investors be considering an allocation to the asset class, which theoretically offers the promise of higher returns driven off demographic trends? I think it’s a worthwhile topic to revisit, while also providing an overview of investor behaviour since that time.
As noted in my article last year, it’s only recently that the correlation between Canadian and emerging market equities has lessened, making the asset class more attractive from a portfolio construction perspective. In reviewing a December 2017 report by Greenwich Associates, it’s interesting to note that overall, Canadian investors reduced their allocation to emerging market equities in 2017.
While the average institutional investor allocated 3.5 per cent to emerging market equities in 2016, this halved to 1.7 per cent in 2017. Allocations were most prominent among defined benefit pension plans, with allocations to defined contribution plans and endowments and foundations small, if existing at all. On average, among more than 200 institutional plan sponsors surveyed by Greenwich, 38 per cent had some allocation to emerging market equities. Usage was greatest among plans with greater than $1 billion assets under management and Canadian subsidiaries of American corporations.
Investor behaviour was broadly consistent across the type of plan sponsor, with the Canadian subsidiaries the outlier; as an average, they increased their allocations, from 1.6 per cent in 2016 to 1.8 per cent in 2017. Provincial/public sector plans, on the other hand, decreased their allocations, from 4.1 per cent in 2016 to 2.5 per cent in 2017. One possible explanation is that Canadian investors have tended to implement their emerging market equity allocations through international and global equity managers, so these managers may have been finding better value in other equity markets.
Looking at the size of the institutional pool, investor behaviour was much more divided. Larger plans, with assets exceeding $1 billion, mirrored the average result, decreasing their allocations from 3.8 per cent in 2016 to 1.7 per cent in 2017. Plans with less than $1 billion, however, increased their allocations to emerging market equities. This was most significant in the plans with assets between $251 million and 500 million, which increased their allocations to 2.3 per cent in 2017, up from 1.3 per cent in 2016. The pattern was similar for plans with between $501 million and $999 million in assets and those with less than $250 million.
In a 2017 survey of Canadian institutional investors, Greenwich found an increased appetite for emerging market equities. Larger plans, with more than $1 billion, and endowments and foundations had the greatest appetite for hiring an emerging market equity specialist manager, with six per cent and nine per cent of, respectively, indicating potential activity. While those aren’t large numbers, they do show an increase from previous years.
Emerging market equities performed well in 2017, so those investors that did allocate to the asset class were happy they did. The MSCI emerging market index, one of the best performing indices, returned 28.7 per cent to Canadian investors in 2017. However, in the first six months of 2018, returns were less exciting, with a small loss of 1.8 per cent to Canadian investors. Given that the TSX composite index returned 1.95 per cent during the same time period, emerging market equity returns aren’t as bad as one might think at first glance.
One concern investors may have in allocating to the asset class is the link between rising U.S. interest rates and emerging market equity market performance. In the past, emerging market nations have required external capital, so they were affected by rising interest rates and, therefore, growth prospects. Thus, the theory in rising rate environments is that developed markets tend to outperform emerging market equity markets. Since 1990, the federal funds rate has a negative 0.43 correlation with the relative performance of developed market equities versus emerging markets equites. However, the average masks some interesting trends.
When measured over rolling three-year periods (as opposed to quarterly measurement periods), the correlation has ranged from as low as negative 0.85 to as high as 0.97. The strong negative correlation occurred in 2002, 2003 and 2004 when the fed funds rate declined. The almost perfect correlation occurred in the three years ending the first quarter of 2007, when emerging market equities outperformed developed market equities even as the fed funds rate rate increased by more than three per cent. This is similar to the past three years, when emerging market equities have outperformed developed market equities even as the Federal Reserve raised rates.
As I noted in my article last year, one of the impediments to investing in emerging market equities has been the poor relative performance versus the MSCI world index. This has resulted from corporate earnings in the emerging market equity markets below those of developed market equity markets. Not surprisingly, there’s a 0.85 correlation between emerging and developed market earnings and their equity market performance (using monthly data since 2003).
Some investors are optimistic about the prospects for emerging market equities given corporate earnings are improving but remain below their historical long-term trend, which isn’t the case in many developed market equity markets. As well, commodity prices remain below their long-term trend. Even though the weights of the energy and materials sectors have fallen in the MSCI emerging market index, from 37.6 per cent in June 2008 to 14.8 per cent in June 2018, real earnings trends have remained highly correlated (0.77) with real commodity prices (measured since 1995). Higher commodity prices have tended to compress profit margins.
While returns in emerging market equities weren’t stellar in the first half of 2018, it appears there are still some reasons to — at the least — stay invested in the asset class, if not consider additional allocations.