Investors: A Growing Taste For Exotic Fare

Investors: A Growing Taste For Exotic Fare

Even conservative investors are tempted by the returns of emerging-market funds

For many managers of emerging-market funds, the biggest problem these days is that folks just love them too much. It used to be that buying stocks in Turkey and picking up distressed debt in Argentina was for hedge fund dynamos and other investors with cast-iron stomachs. But now the fat returns offered by emerging-market equity — and five years of crisis-free developing markets — are luring the kind of conservative investors who have traditionally stuck with U.S. bonds and blue chip stocks. The best proof of a shift: Pension funds are pouring capital into emerging-market funds. “All of a sudden, emerging markets are not the exception but the rule,” says Chuck McKenzie, chief executive of OFI Institutional Asset Management, a division of Boston-based Oppenheimer Funds Inc.

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Just how juicy are the returns overseas? The Morgan Stanley Capital International ((MWD ) (MSCI) Emerging Markets Index clocked double-digit gains for the past two years in a row — the first such spurt since the early 1990s. So far this year, the MSCI index of developing economies’ equity markets is up 19.05% in dollar terms, which beats both the 3.96% gain in MSCI’s developed international markets index and a 1.59% rise in the Standard & Poor’s 500-stock index. Many pension fund managers find those numbers too tempting to resist. “Lots of pension funds are overweight,” notes Christopher D. Alderson, Baltimore-based T. Rowe Price International’s (TROW ) portfolio manager and head of emerging markets in London.

The pile-on worries other institutional investors, who say many underdeveloped equity markets — like those in, say, Brazil and India — are overdue for a correction. The skeptics point to the influx of slow-moving pension money as a signal to cut their allocations. But despite high valuations, many pension managers are drawn to emerging markets because of a dearth of attractive investment options at home. While U.S. interest rates are rising, they are still low by historical standards and have failed to give fixed-income investors much bang for their buck. Stock markets in developed economies such as the U.S. are grinding out single-digit gains at best. At the same time, projected pension liabilities are mounting, a reflection of both today’s low-return environment and demographic trends.

It all adds up to a tough climate for pension fund managers — and a big motivation to make up shortfalls by investing farther afield. “There’s a willingness to take risks in order to get returns,” says Bill Riegel, global head of active equity portfolio management at retirement fund manager TIAA-CREF. That attitude has helped push up emerging-market allocations from pension funds, foundations, and endowments from 9.67% of their total assets under management in 1995 to a record 16.2% — or $1 trillion — last year, according to State Street Corp. (STT ) research unit InterSec.

FEARS SUBSIDE

So far, the bet has paid off. The last major collapse affecting emerging markets dates back five years or more to the Asian financial crisis of 1997, the Russian debt crisis of 1998, and the Brazilian currency crisis of 1999. Since then, many developing economies have instituted reforms to keep fiscal spending in check, built up foreign reserves to protect their currencies, and improved corporate governance. The runup in global commodities prices has also helped reduce volatility and sustain stock rallies. “Emerging markets are becoming more stable than they have been historically,” says Alistair Lowe, director of global asset allocation at State Street Global Advisors. “The fear of the unknown is gradually declining.”

Yet that is precisely what makes some fund managers nervous. Some of TIAA-CREF’s Asia-focused portfolio managers, for example, have started to rotate out of emerging markets as U.S. interest rates creep higher. Even if economic fundamentals remain firm, these markets may have risen too fast to be justified by earnings. “We’ve had two very strong back-to-back years [of high returns],” notes Alderson. “I don’t think we’ll have as strong a third year.”