How can Canadian pension plans promote economic growth in the developing world while still meeting their obligations as pension fiduciaries? Until now, many plans have been buying emerging market debt and equities, but there is an alternative: investment in a microfinance fund.

Microfinance lending has been around since the 1970s. According to a Deutsche Bank report, an estimated $25 billion was at work in microfinance in 2006. More recent research shows that the market for microfinance has grown further and could potentially reach $100 billion. Major European pension funds are investing in this emerging opportunity—for example, prominent Dutch pension funds have been investing in microfinance for a number of years.

Following is a look at the potential benefits and challenges of microfinance, the investing approach and how it fits with other asset classes.

How microfinance works
Microfinance is the process of providing small, short-term loans to entrepreneurs in emerging and frontier markets. If a local business in East Africa needs a small loan (say, $500) to buy inventory, for example, it can borrow from a microfinance institution (MFI). Think of an MFI as a specialized type of bank: it raises money from investors mainly by issuing debentures and sometimes by issuing share capital. It then lends that money out to micro entrepreneurs. There are more than 3,000 MFIs operating across the globe, each responsible for lending, credit and collection activities in its own market.

A microfinance fund—which raises investment capital from pension funds, endowments, foundations and retail investors mainly in developed markets—researches and evaluates the universe of MFIs and makes loans (and sometimes equity investments) to support those MFIs that are “investment-ready.”

A typical microfinance fund holds a portfolio of short- to medium-term loans denominated in hard currencies (U.S. dollars and euros) and some local currencies, with equity exposure used in some funds. A well-constructed portfolio has a diversified term structure, which ensures that there is appropriate liquidity for investors even though virtually no secondary market for loans to MFIs exists at this stage. With these characteristics, microfinance funds can be a good diversifier from traditional equity and fixed income investments and may be useful to include in the absolute return bucket of the asset allocation process.

Key considerations
All Canadian pension funds and endowments seek consistent annual returns with low levels of volatility and good downside protection. A microfinance fund can provide these returns and protection by investing in a portfolio of loans and related securities to a diversified group of high-quality MFIs in a wide range of countries.

Because of the “micro” nature of the economic growth being promoted, microfinance funds were relatively de-correlated from the 2008 financial crisis in the developed markets. An investment in a microfinance fund also has the benefit of supporting developing economies in a tangible and practical way—a laudable goal, provided that the pension plan can meet its fiduciary duties.

While microfinance lending is a well-established practice, with more than 15 years of experience at some MFIs, it does have its challenges. Some recent press coverage has questioned the impact of microfinance investments on poverty alleviation, calling for a more in-depth commitment of industry practitioners on measuring achievement of its objectives. However, microfinance continues to be an important driver of economic development in emerging and frontier economies, where financial inclusion and access to fair, transparent and properly regulated financial services are still limited.

Pension plan sponsors should approach investing in microfinance funds as they would any investment manager search: follow the traditional Four P’s of people, philosophy, process and performance. Some of the specific questions will have to be tailored to microfinance—for example, the process by which the investment manager researches and monitors the activities of the MFIs in which they invest. Plan sponsors will also need to understand the historical experience of the investment manager and any liquidity constraints that may exist.

With stable returns, low correlations to traditional assets and downside protection, microfinance offers a new investment opportunity for Canadian pension funds. It can also meet the environmental, social and governance goals of an investor by promoting grassroots economic growth in emerging and frontier markets. As with all investments, however, pension plan sponsors must perform due diligence, monitoring the investment with the care and attention to detail that it requires.

James Clark is senior relationship manager, institutional investors, with Dexia Asset Management. james.clark@dexia.com

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Copyright © 2019 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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