Fund Investors Leaving US for Emerging Markets

Shanghai, China
Nikada | E+ | Getty Images
Shanghai, China

The Federal Reserve's policy of keeping interest rates low may be serving its purpose of spurring economic growth, but it's also caused some uneasiness for those nearing retirement and wondering about the safety of their retirement assets.

Loath to jump back into U.S. equities for fear of being burned twice, and relatively late in life, many of these investors are seeking new ways to shore up their portfolio and gain income.

It may seem counterintuitive to be "leaving" U.S. assets for emerging markets as a way to gain investment comfort, but fund managers are finding that emerging market stock and bond funds are a destination of choice for more U.S. fund investors.

"Clients need to find income and real returns in a world where safe assets are yielding nothing or even negative after inflation," said Elizabeth Corley, global CEO of Allianz Global Investors. "So how do we make sure we can get people the opportunity for income and the growth they need in a world where gross domestic product growth is going to be lower for the next five years than in the five years before the financial crisis?" she asked.

Directing a portion of a diversified portfolio into emerging markets is an increasingly popular answer.

Gross domestic product just came in at a lower-than-expected 2.5 percent in the first quarter (the forecast was for 3 percent), while the struggle over the federal deficit remains a trigger for market anxiety. Several emerging market countries are showing positive surpluses and decent central bank debt issuance, drawing interest from fund managers, Corley said.

Investors must recognize that there's volatility in emerging markets, but the best way to deal with it is to embed it within a fund, and the fund within a larger portfolio of assets.

The emerging market fund theme is rapidly gaining traction at the expense of other asset classes, according to a study, "The Evolution of Emerging Market Equity Mutual Funds," by research firm Lipper.

In 2001, emerging market companies represented only 3.4 percent of the market cap of the MSCI All-Country World Index, but by 2011 that weighting had risen to 10.7 percent, a 215 percent increase in exposure over those 10 years.

As for performance, emerging market equity funds alone boasted a 10-year annualized average return of 15.34 percent through 2012.

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The asset growth in emerging market equity and bond funds has been strong during a prolonged period of slowing asset growth for fund companies.

In the 10 years through March 31, emerging market equity fund assets grew from $28 billion to $390.1 billion, according to Lipper data. Emerging market debt funds now have $95.3 billion under management, versus $5 billion 10 years ago.

While the recent performance in such equities has been strong, Corley cautioned that some may be overvalued. This year, emerging market equity funds have cooled a bit and are up only 1.09 percent through March, according to Lipper. As a result, Allianz Global is turning to emerging market bonds for more upside.

"We think long-term there is great opportunity there [in equities], but for more immediate upside potential growth in the assets themselves and in the currencies, we are looking at emerging market bonds, in particularly in Asia," Corley said. "If you have courage for it, and if you can take the local currency exposure, you are going to get currency appreciation as well, and we recommend it."

For more risk-adverse clients, Allianz Global is investing in the emerging markets through its target date funds, which provide exposure to a wide variety of asset classes.

"We take our clients risk appetite into account and look for risk-adjusted returns by diversifying asset allocation and geographic exposure while actively managing our funds," Corley said.

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Alan Reid, president and CEO of fund company Forward, also has seen a change in the investor mindset when it comes to emerging markets.

"In the past, emerging markets were more thought of as alternative investments, but now they are more mainstream, offering broad, deep options for clients to invest in," he said.

Marie Chandoha, president and CEO of Charles Schwab Investment Management, agreed with Reid and Corley that the current interest rate environment has presented funding challenges for people ready to retire.

"Low interest rates benefited parts of the economy but not retirees, and it's been a real struggle for those individuals to figure out how to get enough yield without taking too much risk," she said.

"In 2007, Treasury bonds offered 5 percent yield," Chandoha said. "By 2009, you had to buy corporate bonds to get 5 percent yield, and in today's market you would have to buy high-yield bonds to get that 5 percent yield, which means you are taking that much more risk." That has left investment managers scrambling to find new sources of income for their clients.

Allan Roth, founder of financial planning firm Wealth Logic, said that clients' trying different ways to earn extra income has exposed a risk.

"They are going into some of the same sort of things that crashed and burned in 2008—junk is in," Roth said. "People who have saved in a programmatic fashion for retirement to build principal find it very difficult to spend down that principal and want to generate extra income, but putting assets in risky things is the biggest risk to retirement."

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The crush of boomer retirements is a big part of the dilemma.

"The average baby boomer in their 60s, who has done their best to save for 30 to 40 years, can't afford to lose their principal," Reid said. The challenge is to participate in the market while protecting assets.

"This is where advisors need to voice concern over domestic bonds," he said. "Most people are not getting what they want long term in the bond market, and any move in interest rates could have a negative affect on the value of their portfolio. So both investment firms and professionals need to help people think about other options to receive income that will increase or protect their principal other than bond funds that have the potential for volatility on the down side," Reid said.

All that has created a move away from U.S.-centric investing, pushing people to new frontiers, specifically, the frontier markets.