Institutional investors to ramp up EM exposure, says Aon Hewitt
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Foreign Exchange

Institutional investors to ramp up EM exposure, says Aon Hewitt

Aon Hewitt’s annual survey of 150 fund managers, with a combined total of $22 trillion assets under management, shows that managers are anticipating an increase in demand for emerging market (EM) debt and equity among institutional investors in 2012.

“There has been a visible trend where more managers are building up expertise in the emerging market space and launching products that are geared specifically to cater for increasing demand from institutional investors,” says Lennox Hartman, global head of fixed-income research at asset consultant, Aon Hewitt. Aon Hewitt claims there has also been a growing appetite among institutional investors to hold local currency exposure when investing in EM.

In contrast to a typical bond or equity portfolio in developed markets, where unhedged currency exposure is widely seen as a source of uncompensated risk, Aon Hewitt regards the currency element in an EM portfolio as an integral part of the investment.

“While there is volatility associated with emerging market currencies, the FX component is a valuable diversification tool and also an important source of alpha for our clients,” says Hartman.

For this reason, Aon Hewitt does not typically advise its clients – particularly those who are long-term investors – to outsource EM currency exposure to external currency managers.

“We aren’t looking to give that source of return up by passing the FX risk to overlay managers,” says Hartman. “Finding the right managers who are able to manage the risks attached to the underlying assets as well as the currency is our job as researchers and advisers to our clients.”

Russell Thompson, chief investment officer at The Cambridge Strategy, a specialized EM hedge fund, says while EM currencies are a clear source of disposable alpha, investors must be aware of the tail-risks associated with them.

Understanding liquidity constraints in these currencies is another key aspect to consider, according to Thompson. “The liquidity in many EM currencies can change very quickly and it’s crucial to be aware of how much liquidity you’ve got, what your counterparty will quote you and in what size.”

The importance of the currency element for generating returns on EM portfolios is evident when comparing performance of the MSCI EM Index to the returns of EM currency indexes.

       MSCI EM index v EM currencies: Unadjusted returns

     Source: Independent index provider

Andrew Woolmer, portfolio manager at SEB Asset Management, states that unadjusted returns on a basket of EM currencies produced similar returns to the MSCI EM Index but with much lower volatility. Expressing returns at a standardized level of risk shows that investors would be have been better off simply buying a basket of currencies than passively investing in the EM equity index.

    MSCI EM index v EM currencies: 10% vol adjusted returns

 Source: Independent index provider
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