It’s been a tough year for emerging markets, and EM hedge fund managers in particular. Through 1 November the MSCI Emerging Markets index was down 14% while the Shanghai Composite index had fallen 21.2%.

Single managers in the HFM Global Emerging Market Debt Index were down by just over 2% for the year through 30 September, while the HFM Global Emerging Market Equity Index dropped 5.2% over the same period. Emerging markets FoHFs in the InvestHedge Composite Index ended the third quarter down 3.7% year-to-date. September’s 2.2% drop for that peer group doubled the YTD loss.

There are myriad reasons for this, including political and economic turmoil in Brazil and Turkey, trade disputes between the US and other countries, a strong US dollar taking a bite out of emerging market currency values and rising interest rates in the US that have had investors reconsidering the risk/reward trade-off of developing markets. By most accounts, investor interest in emerging markets has taken a hit due to poor performance.

And yet, institutional investors are still allocating to the space. In at least one case – the City of Phoenix Employees’ Retirement System – the allocation is coming at the expense of a developed markets portfolio. Phoenix ERS created its 8% emerging markets allocation last year, when the space looked more attractive, and reduced its developed markets equity target allocation to 9% from 16% to help fund the new mandate.

“It’s been a tough year, and there is always some component of the investor base that will shy away from strategies that have a bad year,” says Chris Walvoord, global head of hedge fund research at Aon Hewitt Investment Consulting in Chicago.

“Recent performance has not helped with interest overall; it’s certainly hurt it. But there’s still a small core that’s interested in the space, which takes more of a strategic view than a tactical view, and strategically I think they’re right that there are opportunities.”

Phoenix picked three emerging markets managers, two active and one passive, and allocated $200m in total to them. The $2.4bn retirement system picked GQG Partners to manage an $80m active growth-orientated emerging markets mandate, LSV Asset Management to manage an $80m value-orientated mandate and Northern Trust to manage a $40m passive mandate.

That ratio of active to passive management is the norm for pension funds investing in emerging markets, according to an analysis prepared earlier this year by Mercer for the Florida State Board of Administration, which is eyeing new emerging markets equity mandates for the $162bn Florida Retirement System.

According to Mercer’s research, among Florida’s pension peers, active emerging markets equity allocations comprise 75.3% of emerging markets portfolios while passive allocations make up 24.7%.

Florida has all its emerging markets equity assets with active managers. The state’s 9.7% allocation to emerging markets equity is also higher than the average large peer pension plan (9.1%) and US public pension plans overall (6.2%).

Other US public pension plans that have made allocations to emerging markets recently include the $2bn Dallas Police & Fire Pension System, which this year doubled the target allocation for its $446.6m emerging markets equity programme to 10%, and the $11.6bn Louisiana State Employees’ Retirement System, which this summer gave a $100m mandate to an emerging markets private credit fund managed by $5.3bn Gramercy Funds Management.

The Texas State University System is also considering emerging markets as an asset category.

Active management
Walvoord says that a small core of institutional clients that are interested in emerging markets are also interested in active management, particularly hedge funds, and have developed beliefs about the efficiency – or the lack thereof – of emerging markets and thus the opportunity set for hedge funds operating in the space.

“I think there are probably more opportunities for active strategies in emerging markets (as opposed to indexing), but kind of hand-in-hand, those opportunities are also harder to take advantage of.”

Brad McKee, managing director and portfolio manager for Gramercy Funds Management’s capital solutions group, which has a large emerging markets private credit presence, says a key element of Gramercy’s approach is hedging downside risk by securing appropriate collateral and lending terms so that investors are compensated for the risk they’re taking. Active management and local expertise play key roles in ensuring those things happen.

Michael Huber, managing member and portfolio manager of Lavien Advisors, a sub-$100m asset management firm whose hedge fund currently has about 35% of its portfolio exposure in emerging markets – principally China – says using indices to gain emerging markets exposure will likely leave investors wanting. At the end of the day it’s about the kind of exposure – and more specifically the kind of risk – investors are getting when they invest in emerging markets.

Take the Shanghai Composite index, for example. Huber notes that the index’s 1,489 constituents are largely dominated by financial companies and old-line industrial and commodity companies. Almost 70% of the index is composed of financial (33.6%), industrials (16.1%), energy companies (10.5%) and materials companies (8.4%).

“You may not want to allocate to the Chinese financial sector,” Huber adds. “It’s a horrible bet, but they’re in there. ETFs and indexes for emerging markets are inevitably dominated by traditional sectors of the economy.”

Not that investors should look to avoid volatility. That’s just not an option in emerging markets. But they should understand where the volatility is coming from and how it might interact with other asset classes in their portfolios.

“Investors looking to be isolated from volatility probably shouldn’t be in emerging markets,” Huber says. “But emerging markets can offer upside opportunity and diversification. In our years of investing we have found that they can be uncorrelated in unexpected ways and sometimes correlated in unexpected ways. You have to ask what’s your risk profile and your tolerance for volatility? How do you take the risk you really want to get the returns you want? Then you have to look below the surface and ask what am I actually getting exposure to?”

The 1997 Asian financial crisis – the so-called Asian Flu – is a good example. In July 1997 Thailand was forced to devalue its currency. The ripple effects in the form of falling currency values, plunging stock markets and political turmoil spread across Asia, even leading to the resignation in 1998 of Indonesian president Suharto after social upheaval in the wake of price increases tied to the fall in value of the Indonesian rupiah.

Contagion risk
A common refrain in the financial industry is that in times of crisis, all correlations go to one. Investors may think they’re well diversified, but if a shock is strong enough it can affect an entire portfolio. Worries about such a shock are popping up in places like Turkey and Brazil.

Turkey’s currency has fallen this year, and its economy is slowing down, in part because of US tariffs on its products. Consensus is growing that the country is heading for a recession or even a depression. There is concern that the country’s central bank may not be effective at mitigating an economic downturn, and that is stoking fears of inflation.

Turkey’s $910bn nominal gross domestic product, 17th largest in the world in total and 63rd per capita, is relatively small, but a lot of European banks have loaned money to Turkey in recent years or have a presence there, including BBVA, ING, UniCredit and BNP Paribas. In mid-August, as the lira plunged against the dollar, the Euro Stoxx Banks index, which tracks European bank stocks fell 10%. For the year-to-date through 1 November, it was down 24.9%.

It doesn’t take much imagination to see how a full-blown economic meltdown in Turkey could spread to European banks, their shareholders and beyond. While the odds of the worst happening in Turkey remain small, the risks associated with a broader emerging market currency hit are large enough to get investors’ attention. Lee Robinson, who runs the Altana Digital Currency Fund, told sister publication EuroHedge that his firm has avoided emerging markets throughout 2018 and cited Turkey as one reason why.

In the run-up to its seemingly up-for-grabs election, Brazil had presented another potential problem, with a cratering economy, a currency in decline, rampant political corruption leading to profligate government spending and one of its most popular candidates, Luiz Inácio Lula da Silva, in jail on money laundering and corruption charges.

Brazilians went to the polls on 28 October and elected controversial far-right frontrunner, Jair Bolsonaro. While uncertainty remains, markets have reacted positively to the news, according to Delphine Arrighi, manager of the Merian Emerging Market Debt Fund at Merian Global Investors.

“Although a socially divisive figure, Bolsonaro has convinced the market that he is Brazil’s best economic option, hence the strong rally across Brazilian assets. The Brazilian real has returned close to 15% since its mid-September trough, bucking a generally sluggish trend across emerging market currencies.”

Bolsonaro’s choice of finance minister, Chicago-educated economist Paulo Guedes, is key to that rally, although it remains to be seen whether the president will be able to form a coalition for reform and implement plans to “put Brazil back on a fiscally sustainable path”, Arrighi adds.

Gramercy’s McKee says the risk for contagion has a lot to do with what’s happening elsewhere in global markets. Often isolated problems remain so when the underlying fundamentals elsewhere support growth.

“It’s a combination of what’s going on in that individual country and how is that different from other markets, not only within emerging markets but globally,” he notes. “An important aspect of contagion is what’s happening in global markets.

McKee says looking at Turkey and recent debt issues in Argentina, the rest of the emerging markets space has held in. He believes that’s largely because growth fundamentals in the space are generally strong.

Importantly, one of the reasons for that is that local capital markets, specifically the banking systems, are more robust now than they were 10 or 15 years ago, which allows isolated incidents a better chance of staying so.

“One of the things that we’re aware of is that if the global markets sell off then typically that’s a risk-off event for emerging markets and it’s harder to hide within the class,” he caveats. “But what we focus in on, especially on the private credit side, is having significant downside protection through robust collateral structures so you’re not adversely affected.”

Portfolio positioning
Huber is avoiding some of the current problem areas. “The political risk in Brazil and Turkey has risen to the point where you can’t quantify or even estimate [it] from an investment return standpoint,” he says. “We look at companies in China, South America, Africa occasionally, and political risk is always a key challenge. I haven’t really gotten the courage to look at companies in Turkey.”

Lavien doesn’t start its research with a top-down look at countries or sectors; instead, it first looks to identify companies that have three key characteristics: alignment of interests with investors, a founder-driven vision, and whether it has a culture of innovation. Huber invests in a concentrated portfolio of companies that meet these criteria and then hedges his exposures with cash.

Lavien’s global equities investing strategy would not lend itself to scale in a pure emerging markets context. “Emerging markets funds doing what I’m doing couldn’t really scale up to billions of dollars in capital,” Huber states.

“This style of investment is somewhat opportunistically constrained in emerging markets unless you allow a few large caps to dominate the portfolio. You’re not going to have a bunch of people managing $10bn unless they include developed markets, as we do.”

Aon’s Walvoord says the capacity constraints in the emerging markets hedge fund space force investors to weigh some considerations like fund infrastructure differently than with developed markets managers. “Hand-in-hand with emerging markets, a lot of these managers are also smaller and so from a business/operational side you have to figure out the things that you absolutely need and insist on those to make sure that clients are protected.”

Finding the upside?
With all the risks inherent in emerging markets, and the lacklustre recent returns, what’s the value proposition? In short, there’s upside to be had.

In an August note, Jennifer Appel, senior research analyst, asset allocation, at NEPC, made the case that although fears about Turkey and its potential spill-over effect are real, the country’s situation is unique, not part of an EM-wide issue, and its impact on global capital markets in real terms is small.

“We continue to advocate for the addition of emerging market assets in many portfolios, especially as the recent broad-based sell-off creates opportunities in local-currency debt and equities,” she wrote.

Add to that the fact that it doesn’t take huge shifts in dollar terms to have a big effect on returns. Investments in emerging markets healthcare opportunities are one example. China spends about 6% of its gross domestic product on healthcare per capita, versus the US (18%) Switzerland (12.5%), and the UK (10%).

But China is aging, and its healthcare spending is set to increase. By 2030, one projection holds that it will increase by nearly 3.5 times, with effects on local healthcare-related companies set to be significant.

McKee says Gramercy understands that all markets – developed, emerging and frontier – go through cycles, as do individual countries within those markets, but long term the fundamentals and growth prospects generated from demographic, industrialisation and education trends in emerging markets are attractive.

Africa, he adds, has a significant energy deficiency in power generation. Countries there have migrated from smaller, less-efficient power plants that are quicker and cheaper to build to larger, more permanent and more efficient power generation sources that are required today to accommodate overall growth and the needs of a larger middle class. He also notes Mexico’s increased focus on oil and gas production and Argentina’s need to invest in infrastructure.

“You can pick up on those trends if you take it down to the micro levels and you find those high-growth opportunities that exist in each market that you can take advantage of and get good returns off,” McKee says.

Huber adds that part of the appeal of emerging markets is the opportunity for countries to leapfrog and skip ahead with respect to technology. In India, China and a large part of Africa, he notes, there has been a shift from having no phones to wireless communication, skipping wired systems altogether.

In e-commerce, countries have moved from cash to peer-to-peer payment systems, skipping cheques and credit cards. These kinds of  developments are part of what can make emerging markets particularly interesting for investors, but they require discipline, a long investment horizon and a meaningful ability to tolerate risk and volatility, he says.

Down = up?
The fact that emerging markets have struggled in 2018 may be a selling point going forward.

“We think we’re at the top of the cycle, so there is market risk to the downside,” McKee says. “But we see that as an opportunity because when there are less market participants we can take advantage of the cycles.

“Fundamentally, if we look specifically on the private credit side, in strong markets it’s harder to negotiate excess collateral and outsize returns. In today’s market it’s a lot easier because we tend to be the last dollar of capital.”

In private credit, the focus has been on the US market for much of the past five to 10 years, leaving fewer players in the space in emerging markets. That works to Gramercy’s advantage, McKee adds, in that the firm can better dictate deal terms and not feel it’s being forced into transactions. In short, it’s still relatively early days for emerging markets private credit.

“We think that the development of private credit in emerging markets is in the third or fourth inning compared to where it is in the US.”

The value propositions going forward for emerging markets investors depend in large part on how they see those investments fitting into their portfolios.

Making the pitch
Bruce Frumerman, founder and CEO of Frumerman & Nemeth, a financial communications and sales marketing consulting firm whose clients include hedge funds, says among savvy investors, interest in EM funds isn’t necessarily focused on particular sectors or regions. It’s more driven by a desire for investments that diversify return sources and risk beyond traditional equity and fixed income.

“Among the smart money it’s become tertiary what the strategy is,” he says. “They want to know what you are delivering: what the characteristics of the portfolio are that may give [them] return beyond [their] core equity and fixed income exposures; what is the added diversification you offer; and how are you managing risk over different market conditions? For the portfolio manager this has become central to any strategy to sophisticated institutional investors.”

Aon’s Walvoord agrees. “Liquidity is the first factor, and the second would be risk control,” he says. “The risk profile of those opportunities tends to be a lot more negatively-skewed – big left tail, or negative convexity as the bond guys like to say. There’s a lot of negative convexity in some of these emerging markets opportunities.

“The biggest thing is to set expectations going in. We try to discuss with our clients what the risk profile might look like for these strategies and make sure they’re prepared for that. We think that they can definitely be rewarded for taking on that risk, but you need to be aware of what the possible outcomes are.”

When they approach investors, emerging markets hedge fund managers are pitching their local knowledge and their expertise as much as their risk management and understanding of macro factors.

In private credit, McKee says that for deal-sourcing firms need people on the ground with the proper contacts and knowledge and the experience to know who the right – and not right – borrowers are.

“At the end of the day, being able to have returns that are attractive on a relative value basis – we understand that there’s greater risk in emerging markets and that the returns need to be such that they make it attractive for investors, but we see that the ability to find and structure deals in a market where there’s less capital chasing deals gives us an advantage for our investors to, on a risk-adjusted basis, find interesting returns.”

Is there still an appetite for emerging markets? on HFM InvestHedge.