Global Investing

The people buying emerging markets

We’ve written (most recently here) about all the buying interest that emerging markets have been getting from once-conservative investors such as pension funds and central banks. Last year’s taper tantrum, caused by Fed hints about ending bond buying, did not apparently deter these investors . In fact, as mom-and-pop holders of mutual funds rushed for the exits,  there is some evidence pension and sovereign  wealth  funds actually upped emerging allocations, say fund managers. And requests-for-proposals (RFPs) from these deep-pocketed investors are still flooding in,  says Peter Marber, head of emerging market investments at Loomis Sayles.

The reasoning is yield, of course, but also recognition that there is a whole new investable universe out there, Marber says:

There has been so much yield compression that to get the returns investors are accustomed to, they have to either go down in credit quality or look overseas. Investors have been globalizing their equity portfolios for 25 years but the bond portfolios still have a home bias. We are starting to see more and more institutional investors gain exposure to emerging markets, and a large number of recent RFPs highlight more sophisticated mandates than a decade ago.

The allocation swing has been especially marked since the 2008 crisis and subsequent Fed money printing that flattened yields across developed markets – the IMF estimated earlier this year that of the half trillion dollars that flowed to emerging bonds between 2010-2013, 80 percent came from big institutional investors.

Here is a chart provided by the Institute of International Finance that shows the stark contrast between retail and institutional investors’ emerging market holdings:

With pension reform, Poland joins the sell-off. More to come

If the backdrop for global emerging markets (GEM) were not already challenging enough, there are, these days, some authorities that step in and try to make things even worse, writes Societe Generale strategist Benoit Anne. He speaks of course of Poland, where the government this week announced plans to transfer 121 billion zlotys ($36.99 billion) in bonds held by private pension funds to the state and subsequently cancel them. The move, aimed at cutting public debt by 8 percentage points,  led to a 5 percent crash yesterday on the Warsaw stock exchange, while 10-year bond yields have spiralled almost 50 basis points since the start of the week. So Poland, which had escaped the worst of the emerging markets sell-off so far, has now joined in.

But worse is probably to come. Liquidity on Polish stock and bond markets will certainly take a hit — the reform removes a fifth of  the outstanding government debt. That drop will decrease the weights of Polish bonds in popular global indices, in turn reducing demand for the debt from foreign investors benchmarked to those indices. Citi’s World Government Bond Index, for instance, has around $2 trillion benchmarked to it and contains only five emerging economies. That includes Poland whose weight of 0.55 percent assumes roughly $11 billion is invested it in by funds hugging the benchmark.

According to analysts at JPMorgan:

The most significant local market impact of the Polish pension reforms is likely to come from index-related selling as the weight of Polish government local currency debt in major global bond indices, including Citi’s WGBI and the Barclays Global Aggregate index, is likely to fall. Our base case scenario sees $3.5 billion worth of index-related selling, with risks skewed to the upside

Japan’s big-money investors still sitting tight

More on the subject of Japanese overseas investment.

As we said here and here, Japanese cash outflows to world markets have so far been limited to a trickle, almost all from retail mom-and-pop investors who like higher yields and are estimated to have 1500 trillion yen ($15.40 trillion) in savings. As for Japan’s huge institutional investors — the $730 billion mutual fund industry and $3.4 trillion life insurance sectors — they are sitting tight.

If some are to be believed, the hype over outflows is misguided. Morgan Stanley for one reckons Japanese insurers’ foreign bond buying may rise by just 2-3 percent in the next two years, amounting to $60-100 billion. Pension funds are even less likely to re-balance their portfolios given large cash flow needs, the bank said.

But a Reuters survey last week revealed several insurance companies are indeed considering boosting unhedged foreign bond holdings.  Insurers currently hold almost half their assets in Japanese government bonds and risk being crowded out of the JGB market as the central bank ramps up purchases.  A recent survey by Barclays also showed Japanese investors keen on overseas debt.

Active vs passive debate: the case of “monkeys”

As CalPERS considers switching all of its portfolios to passive investing,  questioning the effectiveness of active equity investment, there have been some interesting findings that would stir up the active vs passive debate.

Researchers at Cass Business School find that equity indexes constructed randomly by “monkeys” would have produced higher risk-adjusted returns (ie return adjusted by measuring how much risk is involved in producing that return) than an equivalent market capitalisation-weighted index over the last 40 years.

How does this work? Using 43 years of U.S. equity data, researchers programmed a computer to randomly pick and weight each of the 1,000 stocks in the sample, effectively simulating the stock-picking abilities of a monkey.The process was repeated 10 million times over each of the 32 years of the study.  Nearly all 10 million indices weighted by chance delivered vastly superior returns to the market cap approach. Andrew Clare, co-author of the paper, says:

Big Beasts

This week might just have seen a marked shift in how British investors think about their role as owners of companies.

First up we had three of our largest unions teaming up behind a set of governance guidelines which they will wave noisily in the air at AGMs, but more significantly, Tuesday morning saw the first steps towards building the kind of collaborative architecture for investors envisioned by the Kay Review.

As first steps go, it’s fairly tentative (as was the first, first step). In a sparse announcement, the Association of British Insurers, the National Association of Pension Funds and Investment Management Association said they will set up a working group to report back on how collective engagement “might be enhanced to make a positive difference.” It is a response to Economist John Kay’s government-backed report from last July, which argued funds could improve returns to savers by presenting a united front to company boards.

Crisis? What crisis? Global funds grow stronger

Global funds are having a good year.

According to a report by financial services lobby TheCityUK, pension funds,  insurance funds and  mutual funds are on track to finish the year with $21 trillion more of assets under management than when they hit rock bottom in 2008 with the Lehmann collapse.

They are growing for the fourth year in a row, and much more so than last year, thanks to the recovery in equity markets.

All together, the London lobby forecasts these funds will end the year with about $85.2 trillion of assets under managements globally, $5.4 trillion more than last year, while 2011 ended “only” $1 trillion higher than 2010.

INVESTMENT FOCUS-Bond-heavy overseas funds want Obama win

Overseas investors, many of whom are creditors to the highly-indebted U.S. government, reckon a re-election of President Barack Obama would be best for world markets even if U.S. counterparts say otherwise.

For the second month in a row, Reuters’ monthly survey of top fund managers around the world was evenly split when asked whether a win for incumbent Democrat Obama or Republican hopeful Mitt Romney in the Nov. 6 presidential poll would be good for global markets.

The split was clearly dependant on whether the asset manager was based in the United States or not. Domestic funds, by and large, tend to favour Romney; overseas investors Obama.

Fears of collateral drought questioned

Have fears of global shortage of high-grade collateral been exaggerated?

As the world braces for several more years of painful deleveraging from the pre-2007 credit excesses, one big fear has been that a shrinking pool of top-rated or AAA assets — due varioulsy to sovereign credit rating downgrades, deteriorating mortgage quality, Basel III banking regulations, central bank reserve accumulation and central clearing of OTC derivatives — has exaggerated the ongoing credit crunch. Along with interbank mistrust, the resulting shortage of high-quality collateral available to be pledged and re-pledged between banks and asset managers,  it has been argued, meant the overall amount of credit being generating in the system has been shrinking,  pushing up the cost and lowering the availability of borrowing in the real economy. Quantitative easing and bond buying by the world’s major central banks, some economists warned, was only exaggerating that shortage by removing the highest quality collateral from the banking system.

But economists at JPMorgan cast doubt on this. The bank claims that the universe of AAA/AA bonds is actually growing by around $1trillion per year.  While central bank reserve managers absorb the lion’s share of this in banking hard currency reserves,  JPM reckon they still take less than half of the total created and, even then, some of that top-rated debt does re-enter the system as some central bank reserve managers engage in securities lending.

Citing a recent speech by ECB Executive Board member Benoit Coere dismissing ideas of a collateral shortage in the euro zone, JPM said ECB action in primary covered bond markets and in accepting lower-rated and foreign currency collateral had helped. It added that the average amount of eligible collateral available for Eurosystem liquidity operations was 14.3 trillion euros in the second quarter of 2012 — with 2.5 trillion euros of that put forward as collateral by euro zone banks to be used in the ECB’s repo operations of 1.3 trillion.  Critically, the majority of that 2.5 trillion posted at the ECB was either illiquid collateral such as bank loans or collateral associated with peripheral issuers and thus unlikely eligible for use in private repo markets anyway, they added. This process of absorbing low quality collateral in order to free up higher-quality assets for private use has been an approach of both the ECB and Bank of England.

GUEST BLOG: The missing reform in the Kay Review

Simon Wong is partner at investment firm Governance for Owners, adjunct professor of law at Northwestern University School of Law, and visiting fellow at the London School of Economics. He can be found on Twitter at @SimonCYWong. The opinions expressed reflect his personal views only.

There is much to commend in the Kay Review final report. It contains a rigorous analysis of the causes of short-termism in the UK equity markets and wide-ranging, thoughtful recommendations on the way forward.  Yet, it is surprising that John Kay omitted one crucial reform that would materially affect of the achievability of several of his key recommendations – shortening the chain of intermediaries, eliminating the use of short-term performance metrics for asset managers, and adopting more concentrated portfolios.  What’s missing?  Reconfiguring the structure and governance of pension funds.

A major challenge facing pension funds in the UK and elsewhere is the lack of relevant expertise and knowledge at board and management levels.  Consequently, many rely heavily – some would argue excessively – on external advisers.  I have been told by one UK pensions expert that inadequate knowledge and skills within retirement funds means that  investment consultants are effectively running most small- to medium-sized pension schemes in Britain. Another admits that trustees, many of whom are ordinary lay people with limited investment experience, are often intimidated by asset managers.

Pension funds cover the table

As gloomy first paragraphs go, you’d have to go some to top Schroders’ Jonathan Smith’s introduction to a report touting his firm’s momentum investing offering.

“As the global economy continues to de-leverage, the next decade looks likely to be a period of weak growth and low interest rates, punctuated by bouts of heightened instability and crisis.”

Oh but hang on!, here’s Legal & General Investment Management having a go.