Global challenges in asset management

From yield to maturity: Development of local currency debt markets 4 Emerging markets: Alpha, beta or bust?. For a playback of the webinar, click herePanel discussion participants: • Ahm

Commissioned by

A report from The Economist Intelligence Unit

From yield to maturity: Development of local currency debt markets 4

Emerging markets: Alpha, beta or bust? 8

Global challenges in asset management: Emerging markets shift gears is based on two webinar

events held by The Economist this year: one held in Kuala Lumpur on September 3, 2014 and another held in Dubai on October 27, 2014 The webinar events and this report are sponsored by Malaysia’s Islamic Finance Marketplace The focus

of the event in Kuala Lumpur was local currency debt markets—their relative maturity, market trends and obstacles to further development The event in Dubai looked at investment strategies in emerging markets and the relative advantages of active and passive approaches

The aim of both events, which were moderated by

a senior editor from The Economist Intelligence Unit, was to bring together expert panelists

to engage each other in dialogue about how emerging market investing has become a challenge to asset managers The events also uniquely sought to include Islamic perspectives

on the issues in focus for a more diverse and robust discussion

About the report

About the sponsor

Since its introduction more than 30 years ago, Islamic fi nance in Malaysia has developed into

a comprehensive and sophisticated Islamic

fi nance marketplace Malaysia’s Islamic

fi nance marketplace is served by the Malaysia International Islamic Financial Centre (MIFC) Community, founded on the launch of the MIFC initiative in 2006 The MIFC Community

is a network of the country’s fi nancial sector regulators, government ministries and agencies, industry players from the Islamic banking, takaful, re-takaful and Islamic capital market industries, human capital development institutions as well as professional ancillary services companies ranging from legal fi rms and Shariah advisories to tax and audit fi rms and research companies For more information on Malaysia’s Islamic fi nance marketplace, please visit www.mifc.com

One would think that with the S&P 500 in a bull

market and bond yields still generally very low

that asset managers would be struggling to come

up with complaints Such is not the case

Today, the global asset management industry

faces multiple challenges, including navigating

central bank policy divergences, fi nding

sustainable sources of risk-adjusted returns and

managing exposures to myriad risks, including

those stemming from regulatory actions and

political events Mohamed El-Erian, chief

economic adviser to Allianz and chairman of US

President Barack Obama’s Global Development

Council, recently noted the fund management

industry has enjoyed a wave of central bank

liquidity that broadly boosted asset prices, but

needs to consider life without such extraordinary

support “The longer the wave persists, the

greater the challenges it poses for the industry

in future Asset managers would be well advised

to prepare now rather than get caught out when

the wave ultimately breaks,” Mr El-Erian wrote in

commentary published in September.1

Investors in emerging markets (EM) certainly

anticipated the wave breaking last year

Expectations that the Federal Reserve would wind down its quantitative easing programme led to

a broad sell-off in EM assets However, US bond yields have remained remarkably low, supporting

EM fi xed income markets this year

Underlying fundamentals are diffi cult to read, while recent economic data from China and Brazil have not been particularly promising Credit growth in China, which has been a key driver

of economic activity since the fi nancial crisis, dropped in July, the lowest in more than four years before rebounding somewhat in August

Brazil slipped into recession in the fi rst half of the year Argentina’s recent debt default, the ongoing standoff in Ukraine and new political leadership

in India and Indonesia altogether paint a complicated picture

This report is focused on the challenges of EM investing The supposition is that it is no longer prudent to treat EM as a single bloc Growth has shifted to a lower gear in large EM economies, but the impact on investment opportunities is not uniform Economic fundamentals in these markets appear to have become more differentiated and thus investors need to adapt

Introduction

1

1 Financial Times, “Post-QE wave to break over fund managers”, 8 Sept 2014

For a playback of the webinar, click here

Panel discussion participants:

• Ahmad Najib Nazlan, executive director, Amundi Islamic Malaysia

• Badlisyah Abdul Ghani, chief executive offi cer, CIMB Islamic Bank Berhad

• Donald Amstad, director, Aberdeen Asset Management

• Mohd Daud Bakar, founder and group chairman, Amanie Advisors

• Kevin Plumberg, senior editor, Economist Intelligence Unit

For many investors, a question mark has hung over the local currency bond markets since May

2013 when fears of Federal Reserve tapering triggered widespread volatility EM local currency bond funds have suffered net outfl ows of US$4bn

so far this year, in contrast to EM hard currency bond funds, which have absorbed net infl ows of US$16.5bn.2

Are local currency bond markets mature enough

to deal with such an outfl ow of foreign capital? Are the pools of liquidity deep enough to handle sudden reversals in the movement of capital and

do these markets have a variety of issuers to attract an equally diverse investor base? To these questions, the panellists generally agreed that local bond markets in emerging economies have

JPMorgan GBI-EM index, 2011-2014

Source: JPMorgan.

Recovery mode?

Market value (US$bn, right scale side)

4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5 8.0

2014 2013

2012 2011

1,000 1,100 1,200 1,300 1,400 1,500 1,600 1,700 1,800

Yield (%, left scale side)

2 Data as of Nov 6, 2014

JPMorgan, EM fixed income

flows weekly, Nov 6, 2014

From yield to maturity: Development

of local currency debt markets

2

matured signifi cantly and while last year’s sell-off

was painful, the fact that markets have rebounded

relatively quickly suggest resilience to large

outfl ows

“In terms of the way the debt markets have

matured, we have a pretty much full yield

curve,” said Donald Amstad, director of business

development at Aberdeen Asset Management

Unlike a decade ago, there are a dozen markets

where an investor can buy bonds for any duration from 1 year to 10 years It is an important development because foreign investors can adjust their duration, or exposure to interest rate changes, by shifting between maturities and they can aim for higher returns through more complex trades that may require buying bonds from one end of the yield curve while selling bonds on the opposite end of the curve

EM local currency debt market at a glance

• Outstanding debt reached US$9.1trn, or 87 percent of total EM debt, as of December 2012

• Local banks dominate holdings of the asset class, but domestic insurance and pension funds have been

increasing participation in the market

• Foreign investors on average account for 27 percent of local debt demand

• Local currency bond funds have seen net capital outfl ows of US$4bn in 2014, as of Nov 6

VARIETY OF INVESTORS

Citing one of the ways that local markets have

matured, Ahmad Najib Nazlan, executive director

at Amundi Islamic Malaysia, said that there are

today a “myriad of investors” including local

pension funds, statutory bodies and central banks

that make it attractive for issuers to tap capital

markets for funding

Badlisyah Abdul Ghani, chief executive offi cer of

CIMB Islamic Bank Berhad, said that the market

in Malaysia is deep enough to ensure adequate

demand for ringgit-denominated bonds

The depth of Malaysia’s bond market has two

implications, he said First, there is little need for

Malaysian companies to tap foreign bond markets

unless they require foreign currency for their

businesses Second, some foreign issuers have

become keen on tapping the local investor base in

Malaysia for funding and swapping the proceeds

into other currencies

Investors in Malaysia also have a strong appetite

for sukuk issues, another key component of

the local debt market Often referred to as the Islamic equivalent of a bond, sukuk is a structure

in Islamic fi nance that grants investors a share

of an asset, which the investor rents back to the issuer for a rental fee This structure is permitted

by Islamic law, as opposed to traditional bonds, which involve the charging or paying of interest

The continuing strong appetite for sukuk among Malaysian investors could encourage a greater number of Malaysian companies to tap this market, Mr Ghani said

A NEED FOR BETTER TOOLS

Malaysia has the largest local currency sovereign debt market in the ASEAN region But emerging markets as a whole contain many different levels

of maturity

Moreover, many local bond markets still need better tools to provide investors with more

fl exibility Mr Nazlan said: “There are aspects of these markets that have to be developed further,

in terms of risk management tools, the interest rate swap market, the currency swap markets.”

The fact is that by defi nition local currency bond markets have inherent currency risk, which make them a riskier proposition than bonds denominated in US dollars or euros This may deter foreign investors with strict constraints from participating in local currency debt markets Governments in some cases may want

to offer incentives such as the provision of swap arrangements for foreign investors looking to invest in currencies other than hard currencies, Mohd Daud Bakar, founder and group chairman of Amanie Advisors, said He added that advanced swap programmes are needed to allow foreign investors to take a longer term view of a market for without them, it can be challenging for them

to invest “We have to facilitate the risk appetite

of foreign investors,” he said

CORPORATES COME TO MARKET

In another sign of the increasing maturity of the local debt markets, EM companies are expected

to increase their home currency bond issuance, offering investors a much greater array of choices

This is where panellists believe the next phase

of development for the industry lies Mr Amstad said that corporate bonds currently tend to be relatively illiquid and expensively priced

Outstanding local currency corporate bonds grew over 10 percent in USD terms in 2012 to US$6.8trn, though the bonds are not heavily traded and pricing not always so transparent.3 However, companies should increasingly be able to get longer-term fi nancing from the bond markets domestically rather than having to rely

on banks “We are going to see more corporates, including some of the larger SMEs—who

previously only tapped the banking sector—

coming to tap the bond market for fi nancing,” Mr Ghani said

The growth of local currency corporate bond markets will also bring new risks For example,

new EM corporate bond issues may not be rated

by one of the main credit rating agencies on which global investors rely Unrated bonds can

be cheaper than rated ones and thus hold the potential for investors to fi nd value However, picking and choosing between unrated bonds requires capabilities to conduct in-depth credit analysis and awareness of the differences between the advanced and EM landscapes For example, in EM, there is signifi cantly less clarity about the rights of bond holders in the event of a bankruptcy of the bond issuer compared with the

US market

In Islamic fi nance, non-sovereign sukuk issues are also expected to grow, as a greater variety

of “borrowers” become comfortable with the non-traditional structure For established sukuk funds and bond funds with constraints that would allow allocation to sukuk, the potential for added portfolio diversifi cation is likely attractive, particularly after the UK’s fi rst sovereign sukuk issuance in June and Goldman Sachs’ announced plans to issue sukuk Standard & Poor’s Ratings Services forecasts issuance of corporate and infrastructure sukuk in the Gulf Cooperation Council (GCC) and Malaysia to increase over the next few years, owing to growing refi nancing needs of companies and as more organisations establish themselves as issuers of sukuk

GLOBAL FACTORS IN LOCAL MARKETS

The near-term outlook for local currency bond markets may hinge on factors that are beyond the control of local governments The US Federal Reserve is widely expected to raise its benchmark interest rate in 2015, and the European Central Bank (ECB), which is struggling to avoid defl ation, could turn to full-blown quantitative easing (QE) The Federal Reserve’s asset buying programme ended in October and the EIU predicts the benchmark Fed funds rate will rise during the

3 Ashmore, Growing

opportunities in emerging

market corporate bonds,

March 2014

We are going to see

more corporates,

including some of

the larger SMEs—

who previously only

tapped the banking

sector—coming

to tap the bond

market.

Badlisyah Abdul Ghani,

CIMB Islamic

second half of 2015 Rising interest rates risk

triggering outfl ows from local currency bonds, as

the gap between local interest rates and US rates

shrinks

ECB action could actually provide a countervailing

force if it unleashes QE of its own, following in

the footsteps of the central banks of Japan, the

UK and the US Such action could add signifi cant

liquidity to global markets

A SEISMIC EVENT

In Asia, the panellists expect two events will

mainly shape the long-term outlook on local

currency EM bonds The fi rst is the opening of the

capital account and capital markets in China — a

“seismic event” for the global fi nancial system,

said Mr Amstad, who compared its importance

with the launch of the euro The size of China’s

economy means its deeper integration into the

global fi nancial system will signifi cantly change

global capital fl ows

Considering that China is currently not a

constituent of various benchmark bond indices,

the opening of the country’s capital account will

have a major bearing as China’s weight in indices

is going to be “extraordinary”, according to Mr

Amstad The domestic bond market in China

today, for instance, is worth US$3.5trn To put

that in perspective, the JPMorgan Emerging Market Bond Index, the GBI-EM and the Corporate Emerging Markets Bond Index put together had a combined market cap of US$2.8trn as of the end

of 2013

The second event that could shape the outlook for local currency bonds is the formation of the ASEAN Economic Community (AEC), which is offi cially scheduled to come into being in 2015

Though the timetable is uncertain, the AEC is expected to have a profound impact on ASEAN’s local bond markets Mr Nazlan said closer integration between economies and markets in South-east Asia should theoretically result in greater transparency in bond pricing and freer

fl ow of capital across borders

Integrated local debt markets in ASEAN would be

an exception rather than the rule The panellists agreed that while local bond markets have generally matured signifi cantly over the past several years, they remain fragmented on the basis of their different market structures These markets remain highly idiosyncratic, but for active investors that may be a source of potential alpha—or above-benchmark returns Indeed, the growing maturity of local bond markets may require investors to reconsider which strategies are the most effective

The opening of China’s capital account and capital markets will be a

“seismic event” for the global fi nancial system.

Donald Amstad, Aberdeen Asset Management

Market volatility in late October, following Dilma Rousseff’s narrow victory in Brazil’s presidential election, was a good example of one of the main challenges of investing in EM Ms Rousseff’s win – interpreted by investors as detrimental to the broader economy - immediately sent the markets

in a spin Brazil’s real fell 3.1 percent against the

US dollar in a single day to its lowest level since May 2005 and the Sao Paolo stock market slumped

6 percent What is the best approach to navigating these markets: actively managing a portfolio or using a passive approach?

Brazil is also a good example of an EM economy seeing growth slow considerably That only has made the question of what investment strategy

to use even more pertinent Active investors often say that their approach makes a lot of sense

in EM because of the ineffi ciencies in markets that can be exploited by a skilled investor

Andrew Goldberg, global market strategist with JPMorgan, said developing economies are

not a bloc, and “it’s important to drill down, differentiate and know, for example, who’s more susceptible to rising rates in the US versus who’s more insulated” Isolating the impact of growth in the US, Europe and Japan on EM, for example, shows that individual EM countries are affected differently, depending on whether they are commodity exporters or manufacturing economies

DIFFERENTIATORS

Differentiation is certainly part of Mark Mobius’ approach to pursuing EM opportunities Mr Mobius, executive chairman of Templeton Emerging Markets Group, said the markets in which he has the highest conviction are China, India and several frontier economies Drilling down further, Mr Mobius is focused on the banking sector as a way to access the growing wealth of consumers He also is focused on the leisure and healthcare industries

Exclusive one-on-one interview:

• Mark Mobius, executive chairman, Templeton Emerging Markets Group

Panel discussion participants:

• Wan Kamaruzaman Wan Ahmad, chief executive offi cer, Retirement Fund Incorporated (KWAP), Malaysia

• Andrew Goldberg, global market strategist and head of the market insights strategy team in Europe, JPMorgan

• Gaurav Mallik, portfolio strategist, active emerging markets investment team, State Street Global Advisors

• Andreas Zingg, director, head of iShares Middle East & Africa, BlackRock

• Kevin Plumberg, senior editor, Economist Intelligence Unit

For a playback of the webinar, click here

Emerging markets: Alpha, beta or bust?

3

An advantage of stock pickers is that they can

potentially root out opportunities that others

overlook In this respect, frontier markets,

including those in Africa and the Middle East,

are where Mr Mobius has been paying more

attention lately Yet why couldn’t an investor

seeking more exposure to frontier markets, which

are essentially aspiring emerging markets, buy

exchange-traded funds (ETFs) for a much lower

cost than buying an actively managed fund?

That question summed up a dilemma in the asset

management industry today, but it was also an

area where Mr Mobius recommended caution,

particularly when it came to frontier markets

As frontier market ETFs grow in size, it will be

increasingly diffi cult for them to replicate an

underlying index of relatively illiquid markets

without creating an unwanted market impact

“Going into frontiers with ETFs would be a dicey

and risky adventure,” Mr Mobius said

PASSIVE AGGRESSIVE…

Regardless of the debate over frontier market

ETFs, passive strategies are being increasingly

deployed by investors to get wider exposure

to the macro fundamentals of EM economies

Proponents say instruments such as ETFs enable

investors to have a greater diversity of exposures

across EM at a lower cost than actively managed

funds

Furthermore, passive investing is not just

about putting one’s money in an index or ETF

and waiting for it to rise So-called smart beta

investing involves creating tailored indexes

that are not based on the traditional criterion

of market capitalisation Andreas Zingg, head of

iShares Middle East & Africa with BlackRock, said

smart beta strategies are a way to manage – and

even benefi t from – the rise in volatility that EM

stocks have seen in the past year A minimum

volatility index is designed to outperform broader

markets in adverse conditions Mr Zingg pointed out that in the past three years the iShares MSCI

EM Minimum Volatility Index outperformed its parent index by more than 15 percent

OR HYPER-ACTIVE?

On the fl ipside, active investment strategies, although more costly, enable investors to exploit opportunities that arise as a result of market imbalances and differentiated economic growth rates across EM The belief of the active investor

is that the increase in price volatility in EM bonds and equities as well as the divergent economic growth trends are ideal conditions for a skilled manager to sift through assets being unloaded in

a hurry to fi nd interesting opportunities

Gaurav Mallik, portfolio strategist at State Street Global Advisors, said that even in developing economies that are witnessing healthy growth rates and sound fundamentals, it is important to identify the drivers In India, for instance, most

of the growth has come from consumer-oriented sectors, so a recovery may eventually spread to the industrial and fi nancial sectors An active manager would thus drill down in these sectors and fi lter opportunities

In terms of how investors have been accessing active opportunities, Mr Mallik said regional, country-specifi c and small-cap funds have been popular, with the latter being a more recent focus

Mr Zingg from BlackRock added that investors have been increasingly interested in regional and single country EM ETFs as well However, timing bets on the market by using country-focused ETFs

is diffi cult to get right Active stock selection can face the same challenges of market timing, but allows investors to manage the impact of currency

fl uctuations on international investments EM currencies have been a signifi cant source of market volatility in the past year

Going into frontiers with ETFs would be

a dicey and risky adventure.

Mark Mobius, Templeton Emerging Markets Group