Chaos in Egypt? Sliding stock markets in India? Headlines like those have failed to dampen investors’ ardor for emerging markets. In fact, these markets are so popular that more and more 401(k) plans are turning them into a separate asset class, no longer an afterthought wedged into the international equity portfolio. And that trend has some investment experts worried.
“It’s a very volatile asset class,” says Pamela Hess, director of retirement research at Aon Hewitt. “That’s going to lead to too much trading around returns.” Hess and other skeptics don’t dispute that some assets should be in these markets, whose returns have outpaced those of the developed world in recent years and whose economies are expected to continue growing faster. Typically, this includes the 21 countries on the MSCI Emerging Markets Index.
The debate is over how much money to allocate and whether it should be a separate asset class or part of a more diversified international fund.
The trend began three to five years ago, then speeded up in the past six to nine months as investors became more comfortable with these exotic names, according to Gino Reina, who until recently was a senior vice president at Segal Advisors. Where his firm did only 15 searches for discrete emerging markets managers for defined contribution clients last year, “this year we will do 20 to 25,” he predicts. “For any new manager search, it’s standard now.” Hess says that the number of plans offering a stand-alone emerging markets option has doubled, to 20 percent.
Advocates say this needs to be its own asset class because the characteristics of a country like India, the Czech Republic, Mexico, and Turkey are so different from, say, Japan, Germany, Canada, and Italy. “Being separate allows us to be a little more pure in our exposure, in the strategies we’re using,” says Randy Welch, director of investment services at Principal Financial Group. Also, “it’s easier to analyze” the performance.
Another advantage, says Jonathan Shelon, one of two co-managers of Fidelity’s Freedom Funds (its target-date funds), is that “we have the ability to control the allocation,” rather than relying on an international manager’s discretion. The Freedom Funds two years ago set up a separate emerging markets component with 15 percent of the non-U.S. equities.
And if a particular country like Egypt doesn’t seem like a good bet right now, managers adjust in different ways. Shelon says that in his long-term strategy, “we don’t make changes based on short-term market changes.” Meanwhile, Jerome Clark, portfolio manager of T. Rowe Price’s target-date funds, says his managers can simply shift their allocation into a different geographic area, without giving up on the whole emerging markets concept.
But critics have concerns beyond the immediate headlines. When Northern Trust surveyed 97 institutional managers in mid-December, it found fears of a looming bubble in that sector. “The recent strong relative performance in the [emerging markets equities] segment may be boosting valuations to levels that our managers feel are somewhat less compelling when compared to other markets,” Northern Trust reported.
For its part, Vanguard Group continues to keep its emerging markets component safely snuggled within the broader international portfolio, believing that the diversification will help control volatility, a spokeswoman said.
Hess also warns that investors may unwittingly end up allocating too much to the category, because they may not realize that “some of the most popular international funds in 401(k) plans often have one-third of their funds in emerging markets.” Combining the typical international and emerging markets allocations that Hewitt sees, investors could well have 25 percent of their total equity in this volatile sector. By contrast, Hess recommends just 10 percent.
But Welch isn’t worried. “The world is becoming smaller,” he says. “There’s much more of a comfort zone in plan sponsors using this.”
Fran Hawthorne is the author of the award-winning “Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street” (Bloomberg Press) and “Inside the FDA: The Business and Politics behind the Drugs We Take and the Food We Eat” (John Wiley & Sons). She writes regularly about finance, health care, and business ethics.
