New types of long-term investors and flexible, “go-anywhere” investing styles are helping transform emerging markets by making the once-volatile sector less prone to the sweeping sector-wide sell-offs common in the past.

Consider recent events. Macedonia and South Africa successfully tapped bond markets on July 17, as buyers turned a blind eye to the ongoing Russian bond rout caused by U.S. sanctions and the bringing-down of a passenger plane on its border with Ukraine.

Similarly, a day after a U.S. court ruling put Argentina on the road to default, fellow emerging market and serial defaulter Ecuador persuaded bond investors to lend it $2 billion.

And the bank crisis and resulting stock market tumble in Bulgaria made barely a ripple in neighboring Romania or Hungary.

Not so long ago, the sector would have swooned in unison, as during the Argentine debt default in 2001-02, the Russian financial crisis of 1998, and banking crises in Turkey in 2001 and Iceland in 2008.

But increasingly, the new normal is for contagion between markets to be either absent altogether or modest and short-lived.

All that applies to the riskier Western markets, too – recent pockets of volatility such as those caused by problems at Portugal’s Banco Espirito Santo sparked some selling but did not translate into across-the-board routs that shook out bullish bets on Spain or Italy.

Some of investors’ nonchalance is down to the flood of cheap money still being pumped out by developed central banks.

But fund managers reckon steady inflows from big long-term investors such as pension funds—and their preference for flexible, benchmark-agnostic investment models—is helping emerging markets weather the kind of storms that would have flattened them, domino-style, just a few years ago.

“The institutional side has been pretty resilient through all this,” said Ernesto Bettoni, director and strategist in BlackRock’s emerging debt team in London.

“Institutional investors did not capitulate on emerging markets, but what is changing is the way they invest. We have noticed a lot of them are excited by unconstrained strategies,” he said, referring to so-called “go anywhere” funds that eschew the old benchmark-based investing models.

Who Is Buying Emerging Markets And How?

There is evidence that deep-pocketed pension and sovereign funds, insurance firms and central banks—who a decade ago would have shunned emerging markets as too risky – have been buying. Their allocations via mutual funds to emerging equities currently are 9 percent above year-ago levels, data from the Washington DC-based Institute of International Finance shows.

Emerging bond allocations are up 7.5 percent, the IIF says.

Adjusted for price changes, allocations to emerging markets via mutual funds are more than three times as high as they were in 2007 in dollar terms. (See related this graphic, based on IIF data, at

Consultancy Mercer’s annual survey of investors managing 850 billion euros also showed this year that allocation to emerging markets had risen since its previous poll.

“Institutional investors have…taken a relatively sanguine view of the difficulties experienced by many emerging economies in 2013. This stands in stark contrast to the sudden rush for exit by retail investors,” Mercer concluded.

But as Bettoni says, it’s not just who is investing but how they are doing it.

Mass-scale selling that regularly torpedoes emerging equity and bond markets is partly down to the practice of mark-to-market, where the net asset value or NAV of a fund is computed on a daily basis, based on its latest market value.

That often leads fund managers, struggling with one poorly performing asset, to sell down others in the index to preserve profits and prevent a mass exodus of investors from their fund.

But many of the new breed of investors don’t measure themselves against standard benchmarks, favoring funds that can invest across asset classes. In such a fund, Brazilian bonds can reside cheek-by-jowl with UK stocks or German Bunds.

“Where we are seeing the most inflows is unconstrained emerging debt, and that’s from institutional investors who are already familiar with EM debt,” Bettoni said.

Data from EPFR Global bears this out. Blended funds that switch between local- and hard-currency emerging bonds have accounted for the lion’s share of inflows this year, which analysts say suggests a desire for non-benchmark focused funds.

A global multi-asset income fund from Schroders has amassed $5 billion since its 2012 launch. Fund manager Aymeric Forest ascribes this partly to pension funds’ need for steady income.

The fund now has a fifth of its assets in emerging markets up from an 8 percent low, yet its volatility is 5-7 percent, compared with the 10-12 percent that is typical for many dedicated emerging debt funds, Forest says.

“When you buy a benchmark you buy concentrated risk … you may be buying large market cap stocks or bonds from countries that issue a lot of debt,” Forest said. “We are not forced to own any particular asset class or security.”

Custom-Made and Differentiation

Others may prefer custom-tailored indexes—equity index provider MSCI reports that requests for customized indexes have risen by 50 percent over the past year.

Jeremy Brewin, head of emerging debt at ING Investment Management, recounts how his fund had created an emerging debt benchmark that omitted Argentina for one institutional client.

“In the last couple of years, specific clients with specific needs have come to the market,” Brewin said. “We no longer just offer a big red car; if they want a small green car with red spots, we can give them that.”

Brewin and other investors are under no illusion that emerging markets will be immune to Lehman-style cataclysms in the West or even to big and sudden U.S. rate rises.

But all say there is some recognition, even among investors not specializing in emerging markets, that, say, an Argentine default will not necessarily tip Peru or Ecuador over the edge.

That was evident even last year when investors meted out brutal punishment to weak economies such as India or Turkey while others such as Poland or Mexico escaped lightly.

“There is a lot more dispersion now within emerging markets; there are good clubs and bad clubs; some are reformers, others are not, and all that is new. You need to discriminate between them, and we are seeing this already this year,” Bettoni said.

(Graphic by Vincent Flasseur; Editing by Will Waterman)

Topics Trends USA