Capital floods back to Asia

Institutional Investor, April 2010

Institutional capital is flowing back to Asia. As the global financial crisis has eased, so too has concern about emerging market risk among European and North American institutions, and Asia is receiving the greatest benefit.

Fidelity International published a survey in March, conducted by the Economist Intelligence Unit, which studied the investments plans of 100 institutional investors in western developed markets. It found that 90% of respondents expect institutional investors to increase their exposure to Asia over the next three years. In the next 12 months, 58% expect to increase their allocation to China, 47% to India and 30% to South Korea.

One could argue money should never have left Asia in the first place. Capital flight to Europe and the US during the global financial crisis, in the name of reducing risk, looked absurd when the economic performance — and in particular the resilience of the banking system — was so much higher in Asia than in the West. It may be that this time, capital is here to stay. “Over the years a number of big European and US investors have been coming to Asia and examining the dynamics of the market,” says Carlo Venes, managing director and head of institutional business at Fidelity International. “What we’ve seen recently is actual flows, and the survey confirms it is a phenomenon that will stay for some time. These institutional investors have enhanced or included Asia as a component of a more strategic allocation, which – for pension funds and insurance companies in particular – will have a very long timeframe.”

Investment in Asia has perhaps been constrained by the modest role Asia plays in global equity benchmarks despite economic growth. Ex-Japan Asia accounts for less than 10% of the closely-tracked MSCI World Index, for example. Until that increases, a lot of institutional capital won’t increase its allocation to Asia either. But many think such a shift is inevitable. “What we hear a lot from investors is that when we look at the representation of Asia ex-Japan in global GDP, it’s very obvious that the benchmark composition will change dramatically in the next decade,” Venes says. “The smart money is anticipating this ahead of the masses.”

One institution that has been bolstering its standing in Asia is AMP Capital Investors, the Australia-based financial services group. “We have been increasing our allocation to Asian (ex-Japan) equities over the last few years relative to mainstream global shares,” says Shane Oliver, head of investment strategy and chief economist. “The main reasons are that Asia has low levels of private and public sector debt; its financial system is not impaired like the US financial system; Asian countries still have a long way to go to catch up to western per capita income levels; economic policies are generally geared to achieving this catch-up; and demographics are generally far more favourable than in advanced countries.”

“This all results in a superior growth potential for Asian earnings which, when combined with similar valuation metrics to traditional advanced share markets, suggests a superior return potential overall.”

The economic arguments are now widely acknowledged. “Many investors, rightly or wrongly, have been following the simple story of growth and strong finances,” says Hugh Young at Aberdeen Asset Management in Singapore, which runs about US$40 billion in Asian equities and just under US$20 billion in debt. “The rest of the world is in a complete mess, Asian economies and their finances are in good shape, and individuals are not geared up to the eyeballs as they are in the west. That’s the simplistic appeal: the devil is in the detail.”

One example of the devil in the detail is the irksome fact that a booming economy doesn’t necessarily mean a booming stock market. “It’s a leap of faith for the economic story to translate into: ‘therefore we must buy Asian equities and we will make money’,” says Young. “There can be a disconnect between that economic story of wonderful growth, and making money on stock markets. Depending on where you start and stop on the China index, it’s actually done nothing despite 10% economic growth.”

Indeed, China is the best example of this disconnect. At the time of writing the CSI 300 index, a representative index of 300 domestic shares (or A-shares) on the Shanghai and Shenzhen exchanges, was at the same level as it was in April 2007, meaning no share market appreciation in three years during which quarterly GDP growth has often been in double digits. This isn’t universally true – India needs only a 15% burst to hit an all-time high – but it is certainly a mistake to make share investments based purely on the macro picture.

Managers vary in the places in which they see growth. Young prefers India to China when trying to find opportunity. “China we find it just a bit too difficult to find companies that are really run to look after us as shareholders,” Young says. “They can do weird and wonderful things and you get screwed.” Aberdeen’s Asian portfolios have about 40% between the well-regulated and liquid centres of Hong Kong and Singapore, 15% in India, and less than 10 directly in China, including Hong Kong-listed H-shares (Chinese companies with a Hong Kong listing). “The Hong Kong, Singapore and India bias is quite pronounced,” he says. “In Hong Kong the understanding by companies of making money for shareholders is quite well engrained. The same is true for Singapore. Neither is for the economies themselves; it’s more the location of companies operating regionally or globally that know what they are doing.”

The Fidelity/EIU survey does show that investors remain mindful of what they perceive as Asian risk. Partly this is a macro position: 54% of respondents felt that Asia was more prone to asset price bubbles than the West, for example. There is also a concern that tightening monetary and fiscal policy could pull back corporate earnings growth and dampen stock market performance, though this is surely a global rather than an Asian phenomenon. When it comes to individual securities, the majority of the respondents said they felt investing in Asian equities, real estate, alternative assets and currencies (but not bonds or government debt) was riskier than the equivalent asset classes in the West.

Part of the reason for this is a sense that corporate governance and regulation are weaker in Asia than in the West, though it is futile to attempt to generalise about the whole continent since standards vary widely. “If we talk about nine Asian countries they are in nine different stages of development with nine different levels of sophistication,” says Venes. “It wouldn’t be fair to markets like Hong Kong and Singapore if we consider them not properly regulated or lacking transparency.”

Young says corporate governance is “getting steadily better across the region, though there can be a couple of steps back sometimes.” He highlights China Mobile’s recent purchase of a 20% stake in Shanghai Pudong Development Bank as an example of a troubling piece of management. “Were they really thinking of the shareholders or just taking instructions from on high? That can be a risk in any government-linked company, and not just in China.”

For his part, Oliver says: “I do not believe the Asian story is already overbought by investors. The Asian region’s weight in MSCI is still well below its weight in world GDP.” But he does see headwinds, and not just in terms of how US and European recoveries affect the region. “The main short term challenges facing Asia are how to ensure that the cyclical recovery proceeds without generating inflation and other imbalances such as asset bubbles. This points to a progressive removal of the monetary and fiscal stimulus that was pumped through in 2008 and 2009 – but it needs to be done in a way that doesn’t upset the recovery given the global uncertainties.”

The Fidelity survey showed some interesting shifts in the way that Asia’s own institutions invest – an increasingly powerful group in their own right. They are much more likely to invest in Asia’s developed or newly industrialised countries such as South Korea and Taiwan than are those in, for example, Western Europe. This perhaps reflects the fact that Western institutions look to Asia for growth stories, with commensurate risk; while Asian institutions, already exposed to that, are more likely to seek out relatively stable and mature economies such as Korea and Taiwan – perhaps particularly since Western economies don’t look as strong as they used to.

Still, talking in country terms is fraught with difficulty since so many companies are global, making their place of domicile somewhat irrelevant in allocation terms. This is well known in the west – Nestle is a frequently cited example, with a Swiss listing and domicile but drawing only 2% of its earnings from Switzerland and most from emerging markets. But the same is true of Asian companies too. Many investors talking about increasing allocation to Taiwan and Korea may well be talking about two specific stocks: Taiwan Semiconductor Manufacturing Corp (TSMC) and Samsung Electronics, both considered among the most well-run companies in Asia and the bedrock of many institutional portfolios. But they are global companies.

“TSMC is listed in Taiwan but most of its suppliers are in China and its customers are in the US,” says Venes. “If you invest in it you’re not just investing in Taiwan, or in Asia, but a global company.” He argues this is going to have a knock-on effect on the benchmarks that investors track. “We are living more and more in a global marketplace. Investors still like to look at benchmarks from a capital-weighted and regional perspective. But that potentially will change in the next five to 10 years.”

Similarly, many investors may have taken exposure to Asia without ever investing in an Asia-based stock. Buy Coca-Cola or BHP Billiton and you have Asian exposure. The degree to which this emerging market exposure in Western-listed stocks influences investment decisions is hard to quantify, but it is certainly there. “There are a lot of companies listed in the US and UK with big chunks of their earnings from emerging markets that are potentially equally attractive to stocks listed in Asia,” Young says. “It’s the same theme, just a different geographic area of listing.”

BOX: Pensions in Asia

Across Asia, a pensions industry is gaining in scale. Many schemes are still relatively youthful but their direction is clear.

While there are some long-standing state pension funds in Asia – Singapore’s Central Provident Fund dates from 1955 and today has a total members’ balance of S$163.5 billion – many of these enterprises were founded in the 1990s and are only now amassing a truly significant amount of capital.

For example, Malaysia’s Employee Provident Fund was founded by legislation in 1991 and today has 11.4 million members, takes 11% of each member’s monthly salary and as of June 30 2009 had over RM354 billion under management. Hong Kong’s Mandatory Provident Fund was launched in 1998, and as of December 2009 the 38 registered MPF schemes had an aggregate HK$308 billion under management. In China, youth has been no barrier to scale, as one might expect: the National Council for Social Security Fund was set up only in 2000 but by the end of 2009 had RMB776.5 billion under management, up 38% on the previous year.

These are state initiatives, designed to counter the threat that Asia, though in a demographic sweet spot today, will one day have to provide for an ageing population. There are also signs of a private pension fund industry gaining greater traction too. Last year Malaysia announced it would introduce private pension funds in 2010 as part of an overhaul of the overall pension fund industry. It is not yet clear exactly how the system will work in Malaysia but the prompt appears to have been that there are two million self employed people in the country not covered by the formal pension system.

“In comparison to the Calpers of this world the development of the pension fund industry in Asia is pretty much in its infancy,” says Hugh Young at Aberdeen. (Australia and Japan, with some of the biggest pension markets in the world, are not considered in this section.)

The development of these funds, both state and private, will have more and more of an impact on Asian stock markets and allocation trends. “A lot are still exposed to domestic markets, but their size is forcing them to find more diversified international exposure,” says Carlo Venes at Fidelity. “Institutions in Asia are anticipating the same amount of investment into broader Asia as European institutions do.” This, too, might create pressure on benchmark indices to change their composition.

Broadening the net to look at Asian central banks and sovereign wealth funds reveals some vast wealth that could potentially be deployed into markets. Consider the State Administration of Foreign Exchange (SAFE), which has responsibility for China’s reserves: even though the bulk of China’s $2.4 trillion foreign currency reserves are not available to be invested in anything other than short-term liquid money market securities, it is believed that several hundred billion dollars sits in an investment portfolio that includes foreign investment. That’s unlikely to have much of an impact on Asian equities but it could have more and more of an influence on debt securities in the region, and possibly on currencies too. Elsewhere, China’s sovereign wealth fund, the China Investment Corporation, has over US$200 billion under management; Singapore sovereign wealth fund Temasek’s portfolio, when last disclosed in 2009, was worth S$172 billion.