Back in fashion

Emerging market equities were a tale of two quarters this year. US individual investors sold stocks between January and March, according to one experienced fund manager. Hedge funds have been putting money into emerging market equities for many years, however, and asset allocators returned to the asset class during April, May and June.  

As far back as the fourth quarter of 2010, developed markets investors feared China’s economy would overheat. ‘It was a clear trend that money was pouring out of Asia,’ says Nick Arbuthnott, a managing director at Ipreo, the financial data company.

He adds that growth investors pulled $4.2 bn-worth of their assets out of Asia’s emerging markets during the first quarter of this year. Some of that money went into eastern Europe, which won a net $1.5 bn. ‘We saw a very consistent move by regular growth investors out of Asia,’ says Arbuthnott.

Fear spread to US private investors in the first quarter, when they sold $2 bn-worth of exchange-traded funds, notes Jerome Booth, head of research at Ashmore, the emerging markets investment manager. He says these Americans accounted for about $1 in every $2 of outflows, although he concedes that the total outflows are small: last year, $29 bn went into India; this year, $2 bn came out.

The sell-off in January and February hit all sectors except energy and materials, says Edward Lam, fund manager at Somerset Capital Management. ‘Yield was not the differentiating factor – sector was,’ he says.

Stocks surviving the great sell-off include energy group PetroChina, and South Korea’s Posco and Hyundai Steel, the basic materials groups. Taiwan’s survivors include Formosa Chemicals & Fibre, also a materials company. Mobile phone maker HTC was an exception to the rule that emerging markets stocks fell: it rose by more than its significant competitors during the first quarter.

China’s survivors include Sinovel Wind Group, a wind turbine manufacturer, which raised $1.4 bn through an IPO on the Shanghai Stock Exchange in January. Chinese stocks continued to succeed in their IPOs during the quarter, as 93 stocks raised more than $15 bn, according to Ipreo.

Bright future
Booth believes this is likely to continue. He says Asia’s capital markets are tiny compared with its economies and, in most emerging asset classes, the size of the market is determined by demand. ‘Their capital markets, including IPOs, are going to grow faster,’ he says. ‘If people want the paper, the paper will come. If you are an investment banker, go to Asia.’

China, in addition to Japan, wins the lion’s share of investment in Asia, according to Ipreo. China’s share of the market rose by 7.5 percent between January and March compared with the same period of 2010. But the smaller exchanges also enjoyed healthy market share increases: Hong Kong was up by 13.5 percent, South Korea by 28.2 percent and Taiwan by 23.3 percent.

After fear stalked Asian markets, greed returned between April and June, continuing a trend that had begun even earlier. Investors saw less reason to fear China overheating and many reasons to lose sleep about developed equities, particularly those in the eurozone.

‘Most of the serious risks come from the eurozone,’ claims Booth, making his observation during a week when Sri Lanka’s government issued a $1 bn bond at 6.25 percent that was 7.5 times oversubscribed. Meanwhile, Greek government debt was yielding close to three times that level.

New money
So where is new investment coming from as emerging market equities resume their run? Hedge funds account for much of it. In fact, hedge fund investment has been growing for more than 10 years, attracted by strong returns from emerging markets. In the first decade of this century, the MSCI World Index, which measures returns from developed markets, gave a return close to zero. Meanwhile, emerging markets equities provided an annualized shareholder return of close to 10 percent.

Hedge funds followed the money. From 2000 to May 2011, the number of Asian hedge funds has increased from approximately 202 to 1,046, according to figures from Eurekahedge, a data company. During the same period, assets under management have gone up from $19 bn to $134 bn.

Global funds also poured into Asia. ‘So far this year, we’ve seen the majority of Asia’s emerging market inflows coming from global, global ex-US and Korean country funds,’ says Todd Willits, client services manager at EPFR, the financial data firm.

Property buyers were behind some of the activity as the second quarter began. Of foreign direct investment into China in April, about $1 in every $4 went into the property sector, according to Franklin Templeton. The US and Canada provide much of that capital: North America remains the largest source of non-domestic investment in the sector, accounting for more than $600 bn.

Some value investors have provided new money, in contrast to the traditional pattern whereby Asia seduced growth fund managers. Capital World Investors, for example, was a major buyer, notes Ipreo. But it is the hedge funds that the majority will watch to find out whether emerging equities should expect the tale of two quarters to lead to the best of times, or the worst of times.

This article appeared in the September print edition of IR magazine.