Drivers of Investment Flows to Emerging and Frontier Markets

SPEED READ:

• Institutional investors consider numerous, diverse factors when allocating capital to emerging and frontier markets. Many avoid these markets altogether.
• In this flagship MOBILIST study, Intellidex presents findings from interviews with more than 50 market participants, analysing their latest emerging and frontier market allocation strategies, including top-down and bottom-up considerations and the role of information asymmetries.
• This study comes at a critical time for emerging and frontier markets, buffeted after two years of the COVID-19 pandemic by fallout from Russia’s invasion of Ukraine, tightening monetary policy in developed markets, and slowdown in China.
• This context is reflected in the emerging market outlook amongst Intellidex’s interviewees, particularly amongst larger allocators using ‘top-down’ allocation models based on historical data. The study also finds, however, some confidence amongst specialist active managers exploiting ‘bottom-up’ informational advantages to identify quality emerging and frontier market issuers.
• Critically, the study finds that the growing role of environmental, social and governance (ESG) considerations in institutional investors’ allocation strategies may risk diverting capital flows away from emerging and frontier markets, which tend to lack data or score poorly on ESG metrics as presently constructed.
• The report concludes with recommendations for the market and MOBILIST, including steps to solve data gaps, construct new ESG additionality metrics, enhance domestic capital markets in emerging and frontier economies and increase insurance product use.

SUMMARY:

Emerging and frontier markets require significant investment volumes to accelerate sustainable development and fight climate change, but allocations from developed market investors fall short. This shortfall is partly driven by information asymmetries that face developed market investors relative to issuers in developing countries. In this inaugural MOBILIST study, Intellidex investigates what drives institutional investors’ allocation strategies. The research examines the role of information asymmetries, potential solutions and the outlook for allocations to emerging and frontier markets.

The author begins by differentiating between ‘top-down’ and ‘bottom-up’ considerations in investment analysis. Bottom-up analysis considers the attributes of individual issuers or markets relative to peers. Top-down factors are portfolio-wide features exogenous to individual issuers, such as portfolio-level allocation rules, global macroeconomic considerations and cross-cutting exclusions, for example, through the application of ESG screens. The author notes that the balance between top-down and bottom-up considerations varies between larger allocators with generalist mandates and specialist emerging and frontier market houses.

Intellidex analyses the breadth and diversity of allocation strategies, with a focus on the role of informational asymmetries, through over 50 semi-structured interviews with market practitioners. Interviews cover a range of relevant perspectives, including asset owners, asset managers, consultants, sell-side analysts, data providers and other experts. The author maps out different categories of allocator and advisor and how their strategies and perspectives vary, including:

• With USD 35 trillion invested worldwide, pension funds are the single largest source of institutional capital. Interviewees differed in their liquidity requirements and in addition to scale and informational constraints, respondents consistently articulated that reputational and ESG risks prevented larger allocations to emerging and frontier markets.
• Sovereign wealth funds account for more than USD 10 trillion, with a further USD 21.4 trillion held in prefunded public pension funds. The research finds sovereign wealth funds to have diverse allocation strategies, with some focused on domestic development priorities while others followed regional or global strategies.
• Philanthropic foundations, predominantly in North America and Europe, manage some of the most impact-oriented mandates amongst institutional investors; however, this orientation was largely constrained to operating budgets, and did not generally translate into an impact-orientation to foundations’ endowments.
• Retail investors constitute up to 23% of investment volumes in some markets, and in others hold more as a group than mutual funds. Retail investors can hold smaller interests with fewer liquidity constraints but tend to show a home-country bias, limiting emerging market allocations.

The study analyses diverse asset management practices, asset classes across which allocators invest and the indices and benchmarks against which allocators’ performance is measured. For instance, interviewees were consistently unhappy with the influence of benchmarks for emerging and frontier markets. Criticism of these benchmarks stemmed from the clash between index construction rules and portfolio objectives as well as the dominance of particular markets in key indices. Emerging and frontier market specialists tend to have more latitude to invest outside their benchmarks than developed market counterparts; but, indices continue to affect pricing and performance.

Across allocators, benchmarks and asset classes, Intellidex discusses top-down and bottom-up considerations in asset allocation strategy. The traditional top-down case for emerging market exposure had been that these economies offered ‘catch-up’ growth opportunities and scope for diversification in assets uncorrelated with developed markets. This view gained particular traction as China emerged as a major manufacturer and due to an extended commodities upswing before the Global Financial Crisis. Since 2009, emerging markets have on average performed less well than developed markets, leading major allocators to downweight emerging markets. Recently, tightening monetary policy across major developed markets and a slowdown in China have further dampened appetite for emerging and frontier investments.

A critical insight from this study is that the growing prominence of ESG considerations in top-down allocations may risk diverting capital away from emerging and frontier economies. Market participants were concerned that mainstreaming ESG considerations would drive capital away from developing countries, which tended to score poorly on traditional ESG metrics or lacked data altogether. Data shortages and disagreement around key standards, disclosures and approaches to integration were particularly acute in the ‘Social’ domain of ESG, potentially biasing allocations in favour of ‘Environmental’ and ‘Governance’ with more mature standards and data systems.

Opportunities for investments to contribute intentionally and with additionality to ESG performance of issuers and issuing markets were also live considerations amongst allocators. The cost of gathering, analysing and monitoring data for meaningful comparison across issuers and markets is the most significant challenge to greater flows for funds focused on additionality. Interviewees also discuss reputational risks associated with not investing in emerging and frontier markets and in ways that contribute to sustainable development and the fight against climate change in these markets.

Amongst bottom-up considerations, political stability, market regulation, liquidity, domestic market development and, again, ESG factors shaped allocators’ investment decisions within their emerging and frontier market envelope. The study discusses these challenges in some detail but also opportunities created by bottom-up informational asymmetries in emerging and particularly frontier markets. One emerging markets equities manager noted:

The study closes by analysing market-based solutions to information asymmetries, including depositary receipts, secondary listings, total return swaps and risk insurance. The author also discusses exchange-traded funds and investment trusts as structures that may be particularly well-suited to managing allocators’ concerns around information, diversification and illiquidity.

KEY RECOMMENDATIONS AND CONCLUDING INSIGHTS FOR MARKET PARTICIPANTS, POLICYMAKERS, AND MOBILIST INCLUDE: 

• Investing in data infrastructure, particularly for ESG disclosures, is critical to increasing the flow of institutional capital to emerging and frontier markets. It is particularly important in increasing flows to quality issuers aligned with the sustainable development goals and climate finance objectives.
• Developing new indicators that capture additionality in relation to ESG will position emerging and frontier markets more favourably relative to developed markets, where marginal gains are more costly to achieve.
• Enhancing market fundamentals in emerging and frontier economies will take time. Mitigating information asymmetries and reducing data collection and analysis costs can improve the attractiveness of these markets in the nearer term.
• Currently, reputational risks drive capital away from emerging and frontier market issuers that could contribute to sustainable development. Enhancing transparency in relation to geographic allocations of major investors that lack emerging and frontier market exposure would help shift the balance of reputational risks.
• Deepening and enhancing the sophistication of local capital markets is a critical complement to efforts to mobilise international investors. More can be done to connect cross-border mobilisation efforts with development finance institutions’ efforts to enhance domestic capital markets.