Pension funds can’t afford not to have a view on emerging markets, according to Paul Kapsos, portfolio manager, emerging markets, with the Ontario Teachers’ Pension Plan.

Speaking at the Pension & Benefits Summit on April 28 in Toronto, Kapsos added that the long-term risk/return trade-off has been positive to emerging market equities.

But which of the emerging market countries should a plan sponsor choose? Choosing countries with high economic growth won’t help, said Kapsos.

He offered three factors to consider when researching an emerging economy:

  • global (developed market economies, crises, commodity prices);
  • local (demographics, laws, policies); and
  • inherent (growth mathematics, rapid social changes).

Country selection must also be balanced between quantitative factors (growth dynamics, rates and valuations) and qualitative factors (institutional, political and social factors), he reminded the audience.

Kapsos said the outlook for emerging markets for 2011 is “moderately positive,” providing the following evidence:

  • economic growth in the largest economies is decelerating;
  • there’s still a trend of lower volatility growth/inflation;
  • there are lower returns, but emerging markets still have a better risk/return premium; and
  • security selection is becoming more relevant.

The emerging markets discussion then moved to frontier markets, a subset of very small emerging markets.

Frontier markets have a lower market capitalization and less liquidity than more developed emerging markets, said Carl Otto, chair of Cordiant Capital, and they represent 17 of of the 20 fastest-growing economies in terms of average annual GDP growth from 2000 to 2009.

While they account for 22% of the world’s population and 7% of the world’s GDP, they only account for 3% of the world’s market capitalization, he said. (Compare this to emerging markets, with 63% of the world’s population, 42% of the world GDP and 42% of market capitalization.)

As for the actual investing, Otto advocates passive investing in developed markets, but “through fundamental index funds, value-oriented active investing in frontier markets has proven to produce substantially better results than the respective indices.”

When choosing a frontier market equity fund, Otto stressed that the manager should be a bottom-up fundamental analyst—not a top-down arbitrageur between country markets. In addition, the portfolio should consist of sound companies with a history and prospects of growing dividends.

The portfolio should include consumer staples, food, drink, pharma, manufacturing, telecom and financials, he noted. However, there should be little or no exposure to natural resources, Otto warned. In some frontier market countries, the state is putting heavy hand in that sector, where nationalization or excessive taxation is present, he explained.

Otto left the audience with some important advice: don’t restrict your emerging market and frontier market exposure to simply private and public equity funds. Remember to include floating rate loans with an emphasis on infrastructure debt, he said, as these loans are good protection against inflation.

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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