Emerging markets key to pensions growth, say advisers

Over the ten years to the end of April 2009, the MSCI Emerging Markets Index outperformed the UK’s FTSE 100 index by nearly 180 per cent, according to data supplied by emerging markets specialist investor Hexam Capital. In addition to this,  the steep falls experienced by stock markets in developed economies over the past 18 months underscores the argument for UK investors with a medium to long-term horizon to increase their allocation to what has traditionally been perceived as a high risk area, argues Bryan Collings, fund manager of the Ignis Hexam Global Emerging Markets Fund Certainly GDP growth rates in emerging economies appear attractive when compared to developed economies.

For example, in its World Economic Outlook published in April 2009, the International Monetary Fund (IMF) predicts that in 2009 the output of advanced economies will contract 3.8 per cent, while emerging and developing economies grow 1.6 per cent, although this is a substantial fall from their 6.1 per cent growth in 2008. However, the IMF expects these regions to bounce back to 4 per cent output growth in 2010, while advanced economies will neither contract or grow.

However, advisers point out that there are many considerations for investors contemplating increased exposure to emerging markets, even if they are disillusioned with the recent falls in UK and other developed economy stock markets. Andrew Milligan, head of global strategy at Standard Life Investments argues that stock markets do not necessarily reflect growth.

He said: "Stock markets are rarely related to economic growth. Chinese GDP, for example, is being boosted by increasing rural consumer incomes and infrastructure spending, but I am not sure how well this is represented in the Chinese stock market."

"However, western companies should benefit from the infrastructure spending."

Milligan notes that investors can get exposure to emerging market growth via UK-listed stocks such as mining companies and commodity producers, which operate in and make their profits from emerging markets.

Mark Dampier, head of research at Hargreaves Lansdown, also thinks the Chinese stock market at present does not necessarily offer exposure to GDP growth.

In addition, Milligan argues that poor returns from pension funds cannot only be attributed to poor returns from developed equity markets.

He said that pensions funds have exposure to a variety of assets as well as developed market equities, while annuity yields, which are closely correlated to the returns on longer term UK government bonds which offer only around 3.75 per cent, are at historically low levels.

Furthermore, all financial assets have been affected by the financial crisis in the past couple of years, including residential and commercial property.

Nevertheless, advisers generally agree that pension savers with a long-term investment horizon should invest in emerging markets as these countries, in particular China, have very good
long-term growth prospects. Dampier believes that younger savers with 25-30 years to retirement should have at least a 20 per cent allocation to emerging markets, and could consider an allocation as high as 50 per cent.

He said: "If you are 25 years old then it is not a problem if emerging markets crash, as your savings have decades to recover. However, if you are five to ten years from retirement it is very different."

Dampier prefers global emerging markets funds rather than BRIC (Brazil, Russia, China and India) funds, or single country funds. He said: "If the stock market in a country falls, a single country fund has no alternative options."
 
He said good options include the First State Global Emerging Markets Leaders fund, the Aberdeen emerging markets products or the Templeton Emerging Market Investment Trust. He suggests that if investors become more confident they can move into BRIC funds and eventually single country funds.

Martin Bamford, joint managing director at Informed Choice, adds that it is also important that a fund has local expertise and a research capacity on the ground.

Dampier does not suggest exchange traded funds (ETFs) which track a country’s index, because he believes that emerging stock markets are still inefficient so an actively managed diverse fund is better. But Anna Sofat, director of Addidi Wealth, says for single country exposure to China an ETF such as that offered by iShares is better because a number of China country funds have recently underperformed.

Dampier also feels that pensions savers should not necessarily limit themselves to emerging markets equities.

He said: "Investors with a horizon of 25 to 30 years should look to more volatile assets, and these could include private equity or smaller companies funds, but with a good manager. Such assets could bounce back over a ten to 15 year time horizon."

He cites the Old Mutual UK Select Smaller Companies fund, which over five years is the top performing fund in the IMA Smaller UK Smaller Companies fund sector with a 75.9 per cent total return according to Trustnet data, and the Standard Life Investments UK Smaller Companies fund, which is the second best performer with a 61.4 per cent return.

Milligan also suggests high yield bond funds for higher risk, higher return exposure.

But Dampier does not recommend high exposure to emerging markets or other high risk assets if you are five to ten years from retirement, in particular for investors who choose to buy an annuity with their pension pot rather than take income drawdown. Dampier said that investors planning to buy an annuity should start to reduce their allocation to higher risk assets from around 10 years before they plan to retire.

Nick Leitch, head of investment marketing at Scottish Life, said, for example, at this point an equities allocation of between 75 per cent and 95 per cent should come down to around 60 per cent of the pension pot; around five years before retirement this should fall to around 35 per cent, because while this asset class has historically delivered a strong performance over the long term, there is not guarantee it will deliver over five years.

Adrian Boulding, pensions strategy director at Legal & General, said at the point of retirement an investor looking to buy an annuity should have moved the fund to an allocation of around 75 per cent bonds and 25 per cent cash.

However, investors who opt for income drawdown should diversify their pension pots as widely as possible, adds Boulding. This should include up to five per cent in emerging markets, though exact allocation depends on an investor’s risk appetite.

The fund should be mainly exposed to what Boulding terms the main asset classes: major market equities, smaller companies, property, and bonds and cash. But in addition to these investors could hold emerging market equities, commodities, oil and gold.

However, Boulding would include China, still defined as an emerging market, among the allocation to major markets. He said: "China is a driving force in the world economy and is on my list of mainstream international equities."