For many years, passive global equities have formed the bedrock of the growth phase of DC default funds, the rationale being that exposure to broad market beta is sufficient to generate growth over a long time horizon. However, as recent pensions changes and increased longevity have heightened the need for pots that can maintain an adequate level of income during retirement, perhaps schemes should be looking elsewhere to maximise the growth potential for their members. With valuations in emerging-market equities, in particular, having become increasingly attractive relative to their developed-market peers in recent years, we think now could be an opportune time for schemes to consider increasing their allocation to emerging-market strategies that embrace an active approach to stock selection.
The risk-averse nature of many DC default strategies has meant that many trustees may have been reluctant to increase the weighting to an asset class which is perceived as more volatile than ‘traditional’ global equities. However, with a long time horizon of perhaps 20 years or more, schemes can afford to be less concerned about short-term volatility. An emerging markets strategy which invests in high-quality companies underpinned by structural factors that support sustainable growth could offer schemes an attractive balance of risk versus reward over the long term.
While many developed economies face a shrinking working-age population, the demographics of many emerging market countries appear highly supportive of long-term growth.
Differentiation is key
As well as trading at a discount, emerging markets have also seen significant currency rebasing in recent times, and, with a strong US dollar, they can be broadly more competitive. Furthermore, while many developed economies face a shrinking working-age population, the demographics of many emerging market countries appear highly supportive of long-term growth. Nevertheless, there is significant differentiation in prospects between emerging markets owing to wildly different population growth trajectories, credit cycles, export dynamics and governance standards.
Emerging markets are by no means homogeneous, meaning, we believe, that an active approach to stock selection makes sense.
We believe an example of a favourable growth backdrop is India, a market which a typical DC investor might not expect to invest in. The country has strong potential for multi-year growth, owing to a series of economic reforms, favourable demographics, a cyclical credit-cycle recovery and productivity improvements. India’s working population is expected to grow by 30% over the next 25 years and, while less than a third of the country’s population is currently urbanised, this is expected to rise to 40% by 2025. As well as driving demand for housing, such a backdrop should also lead to strong growth potential in related sectors such as housing finance, particularly when it is considered that mortgage debt in India is currently only 11% of GDP compared to 86% in the UK 1. In contrast, South Korea has an ageing and shrinking population, which we see as likely to be a significant impediment to growth over the coming years. Emerging markets are by no means homogeneous, meaning, we believe, that an active approach to stock selection makes sense.
One specific characteristic that may concern investors in emerging markets is the extent of state control, and its scope to distort the investment outlook and act as a dampener on returns. The interests of the state or an oligarch are rarely aligned with those of minority investors, and the governance structures of the majority of emerging-market companies tend to be less transparent than those of their developed-market counterparts. We think the ability to focus on those companies most aligned with minority shareholders, in the context of less stringent regulation around corporate governance in some emerging markets, should help to ensure that the best long-term opportunities can be identified.
With ageing populations and excessive debt creating seriousstructural impediments to Western growth, DC schemes may wish to consider whether an overly conservative approach to asset allocation could act as a drag on members’ returns during the accumulation phase. Despite the acknowledged wisdom that beta exposure is sufficient to provide growth in the early stage of savings, it is our contention that schemes should not neglect the opportunities offered by emerging markets, which have different growth dynamics from their developed-market counterparts. This is an area where it may be worth spending some of the fee budget, particularly given the robust long-term growth drivers in many emerging economies. Such an approach could help to deliver a boost for members during the growth phase, especially if valuations provide an attractive entry point.
Newton defined contribution investments
1 Source: IMF, Global Debt,December 2018
This is a financial promotion. This document is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority. T6331 12/17.