Funds: New money and new strategies

A solid outperformance by emerging-market funds in the first half of this year suggests a new investment cycle is under way. Fund managers report that cash levels have been reduced and fresh money is seeping back into funds for allocation to emerging markets. And while several new vehicles have recently been launched, pools of capital from institutional clients are being formed in segregated accounts for investing in emerging markets.

Emerging markets were up by about 34% in the year to late June, as measured by the IFCI Composite Index. And barring interest-rate uncertainty and a slowing of growth in developed markets, the pace is expected to continue.

Strategist Robert Pelosky, with Morgan Stanley Dean Witter in New York, is convinced the asset class has entered a new multiyear investment cycle that could take the MSCI EMF Index all the way to 700, well beyond its all-time high of 580 set in 1994. While the flow of money into emerging markets funds has thus far not been explosive, the inflows appear to be gathering steam.

At the end of April, a total of about $52.2 billion resided in the top 320 global emerging market equity funds, representing about 95% of the assets in the sector, according to Ian Wilson, editor of Standard & Poor's Micropal Emerging Markets Fund Monitor. The top 150 emerging-market debt funds contained about $7.6 billion in net assets at the end of April. The equity funds leaked about $2.6 billion in net outflows from emerging markets over the last four months of 1998, following the Russian meltdown. But in the first four months of this year the haemorrhaging stopped, with outflows slowing to an aggregate total of just $110 million, according to S&P Micropal.

And managers report that new money has been committed to the funds in May and June. The behemoth of emerging-market funds, Capital International's Emerging Markets Growth Fund, has swelled to about $16.7 billion, compared with $9.9 billion at the end of August 1998. Considering the 56% rise in the IFCI Composite Index from August to the end of April, S&P Micropal calculates that the fund has absorbed about $1 billion in new money from investors during the period - a meaningful amount considering that only a dozen emerging markets funds hold more than $1 billion in total assets.

But after getting singed in the most recent emerging markets downturn, investors remain cautious. "We've recently seen positive cashflows into the [emerging markets] funds and a surge in activity from institutional clients," says Joshua Feuerman, portfolio manager of the $268 million State Street Global Advisors Emerging Markets Fund. "Investors are getting interested again in emerging markets. But they are still gun-shy and somewhat doubtful of the asset class. Some investors, I think, just want to see if we can get through a 12-month period without a major crisis before they commit substantial sums of money."

"The [pension] plans with more than 10% in emerging markets are few and far between," said Feuerman. The key for crisis-weary investors, says Feuerman, is to realize that a lot of the dominos fell in the past two years due to fixed exchange rate currencies. "Now that there are no major fixed currencies left, other than Taiwan, China and Argentina, there are no big dominos left," says the manager.

But he predicts that support for new capital controls from the major world financial bodies, including the IMF and World Bank, will be the lasting legacy of the crisis in emerging markets. "This will mean that funds will have more difficulty in moving in and out of markets in a 12-month cycle and funds will have to adjust their cycle and possibly introduce exit fees," notes Feuerman.

"There has been change in the fund industry for emerging markets debt due to the crisis," says Jerome Booth, head of research at London-based Ashmore Investment Management. "There are fewer players. And the people who are gone tend to have been relative value hedge fund strategists. Those people got blown up. And a lot of people got burned moving from international to emerging markets fixed income. The analysis for emerging markets fixed income is more similar to equity than even to G7 fixed income."

The emerging markets crisis has led some fund managers to make even more profound changes in strategy. Hong Kong-based Regent Pacific, manager of a large family of mainly regional and country funds in Asia and eastern Europe that for long feasted on the most liquid equities in the regions, is shifting its focus away from the public markets in Asia and into more "risk managed" private equity investments.

Regent's chief financial officer, Peter Everington, says "the inevitable decline in the US market" could spell more trouble for emerging markets. Regent is launching a new Asian regional private equity fund and a Korea fund that will invest in distressed businesses in the region. The Korean fund has already acquired a brokerage firm, Daeyu Securities, and is making a $1 billion plus bid for the life insurance company, Korea Life. In addition, a Balkan reconstruction fund is in the works.

Several new funds and sources of capital point to an expanding emerging-markets asset class. American Funds, which is perhaps the most conservative of major fund families in the US, announced in June the launch of its first-ever emerging markets fund, the American New World Fund. But American is not just throwing caution to the wind.

In addition to pure emerging-market positions, the fund will also invest in multinational companies that derive a portion of their revenue from developing markets. WestLB has come out with the WestLB Compass Fund, which includes a series of regional funds for Latin America, emerging Europe and Asia.

Washington-based Darby Overseas Investments, established by former US treasury secretary Nicholas Brady, was scheduled to launch by the end of June two new funds for investing in emerging markets debt: the Darby Emerging High Yield Fund and the Darby Emerging Markets Income Fund. Brad Durham