The Emerging Markets Asset Class in Defined Contribution Plans

Transcription

1 Lazard Perspectives The Emerging Markets Asset Class in Defined Contribution Plans A Multi-Asset Solution Emerging markets have undergone significant changes in the last two decades and now have a prominent position in global capital markets. At first glance, many investors associate the term emerging markets with an equity-only approach. However, we believe a well-considered exposure to emerging markets should look beyond equities to gain access to the full investment opportunity. In this setting, emerging-market investments can provide advantages to both sponsors and participants in defined contribution (DC) plans.

2 2 Summary In general, DC plans tend to be underinvested in emerging markets. By contrast, defined benefit (DB) plans have long considered this asset class in strategic allocations. Heightened regulation and fiduciary standards in DC plans will likely lead to a consolidation of plan options. That is, plan line-ups may be reduced to a handful of investment options to simplify monitoring and fiduciary duties. Elevated historical volatility of emerging-market equity has raised anxiety for some plan participants drawdowns and impairment of capital. At other times, periods of spectacular emerging markets returns have led some investors to chase performance. The vast array of investments in emerging markets drastically expands beyond benchmarks or single-asset solutions (i.e., equity only). In our view, a multi-asset approach is well suited for implementation in DC plans. A combination of emergingmarket assets (in its simplest form, a mix of equity and debt) in one solution has favorable potential features: it addresses streamlined plan menus, mitigates equity volatility, reduces point-of-entry risk, and has a better positioning to benefit from the full emerging markets opportunity set. Including Emerging Markets Has Benefits for DC Plans But Allocations Remain Low Institutional investors with long-term investment horizons (e.g., DB plans, endowments, and foundations) have included emerging-market allocations as a strategic asset class for many decades now. By contrast, DC plans have minuscule allocations to emerging markets or, in many instances, emerging markets are not even an option in DC plan line-ups. In some cases, emerging markets exposure is buried within international equity fund offerings and not as a separate and distinct investment option. The rationale for the underutilization of emerging markets in DC plans is wide ranging, but the most often-cited reasons are: asset class volatility and potential performance chasing/dumping. Vanguard s DC plan 213 recordkeeping data a sample of 3, plan sponsors and $6 billion in assets indicated that only 27% of plans offer a stand-alone emerging markets investment option. Additionally, as of the first quarter of 214, emerging-market equity is only.3% of the total asset allocation in DC plans according to the Callan DC Index (comprising 9 plans and $14 billion in assets). This further underscores the inattention to emerging markets in many DC plans. 1 While Vanguard s and Callan s analysis draws from a fraction of the total DC plan universe in the United States, we believe these data are representative of a common theme. DC plans are progressively commanding a larger share of retirement assets in relation to traditional DB plans. However, DB plans have long tended to systematically outperform DC plans, as revealed by a study encompassing seventeen years of data. 2 This may be partly due to the fact that DB plans maintain professional management for manager research, selection, and monitoring, as well as asset allocation implementation. In several cases, a key feature differentiating DB from DC plans is the former s inclusion of asset classes such as emerging markets, thus extending beyond the basics of domestic equities, core fixed income, and stable value. However, new DC plan fiduciary standards will likely encourage greater rigor and further professionalization of DC plan management. This may begin to level the playing field between DB and DC plans in terms of the robustness of plan menus. A study from BNY Mellon Retirement Group shows that by including emerging markets in an average DC portfolio, returns increased. 3 The average DC portfolio in the study was composed of approximately 59% US equity, 12% non-us developed equity, 2.5% in US fixed income, and the remaining 8.5% in cash and other investments (including a minimal 1% in emerging-market equity). To test the impact of emerging markets on this allocation, the researchers added a 2% allocation which in practice is often lower to emerging markets (a mix of 5/5 emerging-market equity and debt) and reconfigured the DC portfolio. The allocation was mainly funded out of US fixed income (reduced from 2.5% to 1.5%) and US equity (reduced from 59% to 5%). For the twenty years ended December 212, the annualized return for the DC portfolio with emerging markets was 8.4% versus 7.7% for the average DC portfolio, where the difference compounds meaningfully over time. As expected, volatility was also higher in the portfolio with emerging markets (12.2% versus 11%), but risk-adjusted results remained in a comparable range. Emerging Markets Investing: Evolution and Divergence and What It Means in a DC Context Over approximately three decades, emerging-market countries have become a large (and growing) proportion of global capital markets. For example, in 1988 (the inception of the MSCI Emerging Markets [EM] Index) the market capitalization of emerging-market equity was about 3% of the global equity opportunity set. As of June 214, this proportion has grown to about 11%. Emerging-market debt went through a similar trajectory as the market capitalization of hard and local currency, as well as corporate bond indices grew from less than

3 3 $1 billion in 1993 to almost $1.8 trillion in June 214, representing a larger share of global bond markets (Exhibit 1). Economic growth in emerging nations has not been uniform and we believe it is naive to paint all emerging economies with a broad brush. This divergence of growth patterns in emerging markets sets the backdrop to deploy different portfolio construction methods in order to unlock latent value. But we believe further deepening of the capital markets and relatively faster rates of economic growth remain an overall secular trend in emerging markets. The origins of emerging markets investing trace back to the late 198s, when many of the world s institutional asset allocators began to diversify their equity exposure into emerging markets. However, over the past twenty years, many capital controls have been removed, currencies permitted to float, and cross-border trade has increased. As a result, the correlation between emerging and developed markets has risen with globalization, and this process has not been derailed by occasional short-term disruptions. We believe that as the pattern of returns one expects from broad-based emerging markets begins to resemble that of developed markets, diversification must be found by looking deeper within the sub-asset-classes of the broad emergingmarket universe. Exhibit 1 Emerging Markets Equity and Debt Now Represent a Larger Share of Global Markets Market Capitalization ($B) 5, 4, 3, 2, 1, MSCI EM Index 3.% % % 28 Numbers above bars indicate MSCI EM Index market cap as share of MSCI ACWI. Market Capitalization ($B) 2, 1,5 1, 5 J.P. Morgan CEMBI J.P. Morgan GBI-EM Global Diversified J.P. Morgan EMBI Global Diversified 1.% % % % % 214 Numbers above bars indicate the sum of EMBI, GBI-EM, and CEMBI market cap as share of the Barclays Capital Global Aggregate Bond Index. As of 3 June 214 Source: J.P. Morgan, MSCI As most plan sponsors and plan participants have sat on the sidelines, assets invested in emerging-market equities and debt have grown in the last decade. Interestingly, many investors remain allocated to passive benchmarks, which do not offer full access to the depth of the excessreturn opportunity in emerging markets. Indexing naturally leads to large-cap bias, sector concentration, and other unintended risks. In the equity space, the most visible benchmark the MSCI EM Index contained 824 companies, representing 31% of the companies listed in the broader MSCI Emerging Markets Investable Market Index (as of December 213). The equity opportunity is much broader than the popular benchmarks and different parts of the investment universe are attractive at different stages of the economic cycle. Similarly, the market capitalization of emerging-market debt has grown significantly in the last ten years. Local currency debt and corporate debt have risen in prominence, increasing the size and diversity of the opportunity set. In our view, there are five key investment verticals in the emerging markets: small and profitable companies, growing companies, established companies, currencies, and debt. In turn, each of these has different fundamental drivers, which are positioned for particular environments. Taking a page from the DB sponsors playbook, a well-considered emerging markets offering in a DC plan should take into account the diversity of the opportunity where multiple assets (i.e., equities, currencies, and debt) can be combined into an optimal mix. However, this appears at odds with the trend for condensed plan menus. The average DC plan currently offers between fifteen to twenty investment options and due to regulatory pressures as well as recently heightened fiduciary standards the DC plan menu is expected to dwindle to just a handful. 4 A multi-asset solution elegantly tackles this challenge by proposing a central solution for emerging-market investments taking up only one spot from the limited quantity of investment options. DC plan sponsors would also benefit from the reduced complexity of monitoring one emerging markets fund in the menu versus keeping track of five or more funds. What Can Be Done about Volatility? Historically, emerging-market investments have produced attractive returns, but many investors remain concerned about the volatility of the asset class, especially equities. In many cases, plan sponsors are concerned about over-allocation (or in extreme cases a 1% allocation) to investments with favorable recent performance (i.e., so-called chasing returns). In other instances, DC fiduciaries worry about the potential for large losses due to volatility-induced drawdowns. On the other hand, plan sponsors that have included emergingmarket equity in their menus have often relied on this asset class as an important source of returns. As an illustrative example of emerging markets utilized in the context of a long-term-return goal consider the following: Assuming an annualized return target of 8% and selecting a random Wednesday after 31 December 1993 to enter the market, in holding periods longer than five years emerging-market equities would have a significantly higher probability of success than their developedmarket peers, as seen in the top chart in Exhibit 2. Some plan sponsors

4 4 Exhibit 2 The Case for Emerging Markets Multi-Asset Investment Mitigating Point-of-Entry Risk a Had you selected any random Wednesday (since 1993) to enter the market, and aimed at achieving an 8% annualized return... Probability of Success (%) may be under the impression that adding a debt component to their emerging-market equity allocation could depress returns. However, for the period analyzed in Exhibit 2 a hypothetical allocation consisting of both emerging-market equities and debt would have enhanced these results further mitigating point-of-entry risk by curtailing drawdowns. The bottom chart in Exhibit 2 shows a risk/return scatter chart for typical DC plan asset classes in addition to emerging markets equity and debt. The combined emerging markets allocation (Blended Index) generated a favorable pattern of returns within this group. Mitigating point-of-entry risk and curtailing drawdowns are critical concepts for multi-asset investing in emerging markets. Evaluating a Potential Multi-Asset Approach to Emerging Markets 1M 3M 6M 1Y 2Y 3Y 4Y Blended Index EM Equity Developed Markets Equity Developed Markets Equity and Debt Pattern of Performance b Annualized Return (%) US Fixed Income 5Y 6Y US Equity Blended Index 7Y International Equity 8Y 9Y 1Y Holding Period EM Equity In our view, as capital markets become broader and deeper, it is increasingly difficult for an investment professional to simultaneously research global mega-cap names, fast-growing domestic players, currencies, and fixed income. While there are definite synergies between the work that our emerging-market investment professionals undertake at Lazard, we encourage specialization not only within an asset class but also more narrowly in an investment style or sub-asset class. The Lazard Emerging Markets Multi Asset team invests across five broad strategies, each serving a distinct role within a portfolio, with the help of five dedicated teams (small cap, growth, value, currencies, and debt). This is a particularly relevant consideration as it can serve as a central emerging-markets solution in a DC line-up in light of the potential future regulatory trend toward plans with fewer offerings. Heightened fiduciary standards also mean that plan sponsors should carefully evaluate the depth and expertise of investment managers Annualized Return (%) Annualized Standard Deviation (%) Annualized Standard Deviation (%) EM Equity Blended Index a As of 3 June 214 b For the period 1 January 1994 to 3 June 214 Returns gross of any applicable fees, taxes, and expenses. Blended Index = 5% MSCI EM Index/25% JPM ELMI+ Index/25% EMBI Global Diversified Index; EM Equity = MSCI Emerging Markets Index; Developed Markets Equity = MSCI World Index; Developed Markets Equity and Debt = 5% MSCI World/5% Barclays Capital Global Aggregate Bond Index; International Equity = MSCI EAFE Index; US Fixed Income = Barclays Capital US Aggregate Bond Index; US Equity = S&P 5 Index. Past performance is not a reliable indicator of future results. The information in the charts above is for illustrative purposes and does not represent any product managed by Lazard. The indices listed above are unmanaged and have no fees. It is not possible invest in an index. Source: Lazard, J.P. Morgan, MSCI, Barclays, Standard & Poor s Simply dividing and then blending the emerging world s investment landscape in this way is no guarantee of success. Fluctuating market conditions call for different portfolio configurations, so it is essential to align the portfolio with the economic environments across the emerging markets. Given that there are no clear delineations between economic stages, the Lazard Emerging Markets Multi Asset team continuously forecasts the economic environment over the next six to twelve months, categorizing four main subject areas: the macro economy, asset valuation, market liquidity, and investor sentiment. By assigning probabilities to the underlying indicators in each of these areas, we approximate our market forecast that drives portfolio positioning (i.e., the mix of equity, debt, and currencies). Embracing a flexible asset allocation approach in the emerging markets can equip plan sponsors or participants to take better advantage of, and protect against, market fluctuations. Understanding the business cycle, and where individual companies fit within it, is an advantage when building strategies from the bottom up and when allocating capital between strategies. This knowledge gains practical value when aligned with a thoughtful macroeconomic forecast, as the combination can help an investor identify an optimal asset allocation mix at any point in time.

5 5 Conclusion While many institutional investors have long considered emerging markets as a key component of their strategic investment allocations, many DC plan sponsors have avoided adding emerging markets equity as a stand-alone option, and have done so rationally. The combination of inherent volatility, diminishing diversification benefits, and the potential for participant misuse has led some plan sponsors to believe the risks associated with emerging markets equity have grown to outweigh the long-term return benefits associated with the asset class. With over twenty years of experience navigating the emerging markets, Lazard is not only a pioneer, but a leader in the asset class. The firm has grown to manage over $69 billion of equity and fixed-income emerging markets assets, in a platform composed of more than sixty investment professionals. 5 Drawing from this depth and expertise, the Lazard Emerging Markets Multi Asset team is uniquely qualified to deliver a solution that we believe is well-suited for DC Plan sponsors as they continue to strive to improve participant outcomes. However, the evolution of emerging markets has produced an environment that beckons a multi-asset structure. A multi-asset approach can provide DC plan sponsors with the ability to give their plan participants the opportunity to capture the growth potential of emerging economies without subjecting investments to the full risk of emerging stock markets. In addition, a multi-asset solution can help dampen equity volatility toward a more favorable pattern of performance, while also relying on professional asset allocation to tactically invest in subsets of the emerging markets universe. For DC plan sponsors, a group of emerging-market assets combined into one investment option is in line with the trend toward streamlined plan menus. Notes 1 How America Saves 214: A report on Vanguard 213 defined contribution plan data. Vanguard, June 214. Callan Associates, The Callan DC Index: dcindex/ 2 Mc Farland, Brendan. DB Versus DC Investment Returns: The Update. Towers Watson, May 213. The results indicate that for the period the average annual return of DB plans was 8.1% versus 7.25% for DC plans. Compounding these returns for a 3-year period and assuming a $1 initial investment, the DB plan would have $1,9 and the DC plan $ Capone, Robert G. Retirement Reset: Next-Generation DC Solutions with Non-Traditional Components. BNY Mellon Retirement Group, June Baghai, Pooneh, Celine Dufetel, and Elizabeth McNally. Capturing the Rapidly Growing DC Investment-Only Opportunity: The Time for Decisive Action Is Now. McKinsey & Company Financial Services Practice, May As of 3 June 214. 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