Emerging-markets equity up against capacity wall

Apr 17, 2011 @ 12:01 am

By Drew Carter

As many as half of the most sought-after emerging-markets-equity managers have closed their strategies, many at the end of 2010.

The reasons: years of strong performance and inflows from institutional investors.

Looking to these rapidly growing economies to boost equity returns, investors have crowded into long-successful strategies. And in emerging markets, which are smaller — and at times less liquid — than developed ones, capacity is more constrained.

As a result, finding a quality emerging-markets manager is getting more difficult.

That was the experience of The Vanguard Group Inc. when the cost-conscious manager sought subadvisers for its Vanguard Emerging Markets Select Stock fund, a retail fund expected to be launched by the end of June.

Closures have “narrowed the field considerably,” said Dan Newhall, principal in the portfolio review group at Vanguard. “Many have closed or grown their assets so large, it wouldn't really make sense for us to engage their services,” both because of limited remaining capacity and less of an interest in negotiating fees.

About one manager in four has closed its strategies to new investors in recent years, with a flurry at the end of 2010, said Debbie Clarke, a partner and global head at the equity manager research boutique Mercer LLC.

“A lot of our highly rated managers have closed,” Ms. Clarke said. “At the margin, it makes it harder to find quality [institutional] managers.”

“The list is shrinking,” said Ulla Agesen, U.K. head of equity manager research at Aon Hewitt. She said that as many as half of the strategies recommended to clients have closed over the years.

“There are always new ideas, but it is clear that a number of the good [strategies] have closed,” Ms. Agesen said. “That doesn't mean there aren't other opportunities, but less so.”


Emerging-markets-equity specialist Comgest SA stopped actively marketing to new clients in December, while William Blair & Co. LLC is considering closing its strategy to new clients, too.

Comgest has not closed its flagship global emerging-markets-growth equities strategy, but since December, “we are respectfully declining to participate” in searches, said William Holmberg, manager of investor relations. The firm ran $12.9 billion in the strategy as of Dec. 31, up from $5.1 billion three years earlier, according to eVestment Alliance. Mr. Holmberg said the decision was made to stop marketing the strategy following “significant” inflows in 2010. “While we were not blind to what's going on in the markets, it was mainly a bottom-up decision” based on limiting ownership stakes in individual companies, he said.

Comgest declined to provide flow data, but assets in the strategy grew by $5.5 billion in 2010, according to eVestment. Comgest's average annualized returns for the 10-year period through Dec. 31 were 19.85%, versus 15.89% for the MSCI Emerging Markets Index. That put Comgest in the 22nd percentile among eVestment's universe of 98 strategies.

Simo Sorsa, an emerging-markets-equity research analyst at Russell Investments, said limiting flows from new clients “is very much correlated with good performance. They've generally got good performance, long track records, are well-known and have good distribution.”

Ms. Agesen said: “We generally favor those managers that have a very clear view on what assets they can manage in their particular region or style,” so capacity is a major issue when reviewing emerging-markets managers. “It is a question that is on top of our list — when you are going to close,” she said.

William Blair & Co. LLC is considering closing its $4 billion emerging-markets-equity strategy, in large part because of capacity constraints regarding investing in midcap and small-cap companies.

“We have told clients and consultants all along about our capacity constraints because of our inclusion of small-cap and midcap in our strategies,” said Jeff Urbina, a principal and portfolio manager at William Blair. The firm closed its international small-cap strategy for capacity reasons March 31. Emerging-markets equities make up 25% of that strategy's holdings.

Like other managers with emerging-markets strategies, William Blair has seen significant asset growth and strong performance. The firm's emerging-markets strategy delivered an average annualized 20.02% for the 10-year period ended Dec. 31, versus 15.89% for the MSCI Emerging Markets Index, according to eVestment Alliance. That puts William Blair in the top quintile for the decade among eVestment's universe of 98 strategies.

William Blair started an emerging-markets strategy that invests in large-cap companies in April 2008. That strategy, which is not as susceptible to capacity constraints, returned 24.65% for the one-year period through Dec. 31, versus 18.34% for the MSCI Emerging Markets Large Cap Index.

Aberdeen Asset Management PLC, First State Investments, Lazard Asset Management LLC and Robeco Group NV all closed their emerging-markets-equity strategies to new clients more than a year ago.

Managers noted that they need to limit inflows into emerging-markets strategies to protect capacity for other strategies they run — for example, a global equity strategy that also invests in emerging markets or, in William Blair's case, the overlap of international small-caps. “[Capacity] needs to be seen at a firm level, not just as an individual-strategy issue,” Ms. Agesen said.

Although capacity constraints are the main reason managers close strategies to new clients, several other factors come into play as to why and when a certain manager might shut the spigot of new inflows: The manager's investment process, investment horizon and even business pressures contribute, consultants said.

“If you are a value manager and buy and hold stocks for a long time,” capacity pressures will be less than those on higher-frequency trading managers, Mr. Sorsa said. “That number [at which a manager will limit inflows] is very dependent on your [investment] style.”

Market conditions also play a role, and entry points matter. At the end of 2010, stock prices in emerging markets had become a bit stretched, plus inflows picked up as more investors started to see the need for exposure to emerging markets. As performance of emerging-markets equity started to decline and slip behind that of developed markets last fall, equity managers might well have stopped taking new clients to avoid poor performance from the start for the new clients.

“There's the risk that when you take on [a new mandate when valuations are stretched] your client expectations could be quite tough. So the conclusion is, "Perhaps we ought to be sure we're taking on clients who are investing for the long term,'” Ms. Clarke said.

Consultants said the effect of narrowing the field of quality strategies caused by capacity constraints is being countered by the introduction of strategies such as hedge funds' going long only with equities.

Robeco, for example, closed fundamental emerging-markets-equity strategies in November 2009 and February 2010. Instead, the firm has added quantitative strategies, including a low-volatility one that offers completely new capacity to the fundamental ones, said Wim-Hein Pals, head of emerging-markets equities.

Drew Carter is a reporter at sister publication Pensions & Investments.


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