02 Feb 2011, Magda Ali, Structured Products
Despite the uncertainty surrounding the direction of the financial markets, one thing that banks tend to agree on is that the current engine of global economic growth is emerging markets. Asia and other emerging economies have been producing more than they can consume and domestic interest rates are heading higher to combat mounting inflation concerns. Meanwhile, Western policy-makers are holding rates near zero as the developed economies remain fragile.
As the world adjusts to the soaring investment requirements of emerging markets, MSCI predicts that by 2025 they will account for most global savings and investments. In its quarterly review published in December 2010, the Bank for International Settlements said that turnover in foreign exchange derivatives in emerging markets is rising at a significant rate, with an increasing number of cross-border deals. The strength of their external balance sheets and improved policy frameworks has also attracted increased institutional investor interest.
Past growth rates and favourable demographics have repeatedly made emerging markets a popular theme among investors and structured products providers. "The focus on emerging markets over the past couple of years has presented a prime opportunity for index development," says Deborah Ciervo, senior director of international markets and products at Dow Jones Indexes in New York. "We are seeing more customised emerging markets exposures. Clients don't necessarily want broad emerging markets coverage - they may just want specific companies with growth potential." Investability and accessibility are the two most important factors when customising indexes for structured products, says Ciervo. "In recent years, broad emerging markets indexes were more sensitive to performance trends than their developed market counterparts."
While investor demand for structured products covering these themes has mostly originated in Europe, says Alka Banerjee, vice-president of global equities at Standard & Poor's (S&P), demand for emerging markets themes is increasingly coming out of Asia and Latin America, particularly for exposure to specific countries, regions, or subsets. With more than 30 indexes covering over 2,000 companies in 57 emerging markets, S&P has been aggressively developing its emerging markets indexes. "We have seen a revival of the Bric [Brazil, Russia, India and China] theme, as well as variations such as Brict - which includes Turkey - and other combinations of emerging markets countries and regions," says Banerjee.
Other popular themes include Asia infrastructure, and the IFC Carbon Efficient index, which measures the performance of investable emerging markets companies with relatively low carbon emissions while closely tracking the returns of the S&P/IFCI LargeMidCap Index.
"As risk associated with generating attractive returns rises, investors seek to limit that risk," says Banerjee. "But diversifying risk through asset allocation might not be enough during periods of high volatility." S&P has launched risk control versions of many of its indexes, including emerging markets benchmarks. The indexes switch between the riskier underlying index and cash allocations to target a defined volatility level.
Banks are witnessing more demand for emerging markets exposure from private and retail investors alike. "Investors are still going for the standard Bric-themed exposure, especially on the retail and private side," says Ahmad Chaudry, director in equity and custom index structuring at Royal Bank of Scotland (RBS) in London. "There was a bit of a hesitation in getting exposure to Russia out of all the Bric markets in 2010, but for the most part, the Bric countries still remain a big theme." Investors want emerging markets, but they also want some form of risk management, he says. "When these markets are very volatile, access products and capital-protected structures may not provide investors with the desired risk-return profile."
Last year, RBS launched a series of exchange-traded structured notes in Germany linked to emerging markets stocks from Indonesia, India and Chile. The bank says it intends to increase exposure to emerging markets equities, given the favourable environment for high-risk assets generally and the positive momentum for these markets. It has seen interest from investors in structures linked to a number of emerging and frontier markets: Peru, Columbia and Nigeria, along with some interest in Kenya. Banks are now more in tune with how exposure to emerging markets is executed and achieved, says Chaudry. "If the emerging markets do fall, investors believe they will fall quite dramatically." Demand for exposure to the Middle East has been very strong, he adds, but gaining exposure to these markets has been difficult due to local regulations, such as foreign ownership restrictions.
As the structured products market returns to more normal issuance levels, the case for simple structures is still there. "The appetite for complex products in any sort of market has died down," says Konrad Sippel, executive director and head of sell side at Stoxx in Zurich. "We are seeing a shift to easy structures in more exotic markets." Civets markets (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) look increasingly attractive to investors, he says. "Their diverse, dynamic and politically stable economies offer rosy investment opportunities."
Most banks do not have direct trading access to exotic emerging markets, which can pose challenges. "Exotic markets are much more driven by political events because they don't have stable economies," says Steven Goldin, managing partner at Parala, a boutique investment consultancy in London. "Banks are unable to trade exotic markets due to the huge amount of risk, and it is therefore more a play on the countries rather than a technical analysis of specific companies, says Goldin. "The more developed an emerging market economy is, the more you are able to invest company by company," he adds.
HSBC's single country exposure to frontier, Bric and Civet emerging markets proved popular among investors last year, but broad index exposure was not as attractive. "Reluctance [to make short-term investments] in these markets because of their illiquidity and inaccessibility is driving uncertainty in emerging markets," says Alain Alev, head of equity derivative sales for Europe, the Middle East and Africa at HSBC in Paris. "With certain European clients who have retail networks that are less naturally involved in emerging markets, there can sometimes be reluctance to diversify more into them, essentially because the clients lack the knowledge of this market and are sometimes deterred by the increased volatility."
There is a general consensus that Asia and Latin America offer the best investment in terms of performance trajectory and relative risk compared to emerging Europe, which banks predict will lag in terms of popularity and performance due to the overhang of the sovereign debt crisis in Europe.
"The durability and strength in these markets are what sell them as themes," says Timothy Ash, head of emerging markets research at RBS in London. "The question is whether Asia will be able to maintain its unrivalled position as the stronger region in terms of growth dynamics." This may however change due to the volatility in emerging markets, he says. "Emerging Europe, Latin America or Middle Eastern regions may take up the torch and catch up." The bank has seen some credit spreads tighten, and as a result new names came into the market, including Belarus and Yemen. "This suggests signs of overheating," says Ash. Emerging markets may offer attractive opportunities for investors, but they have many risks and complexities and returns could vary significantly across markets, he says.
Obtaining different types of exposure does not necessarily change the way a product is structured. The efficiency of using derivatives, for example, in order to more closely track indexes is true almost universally. The MSCI Emerging Markets Index Fund, the most common emerging markets underlying in structured products, was up 13.8% in 2010, compared to 74.5% in 2009. The MSCI Frontier Markets Index, which lagged behind the developed and emerging markets indexes during 2009 with a return of just 7%, performed best in 2010 with an 18.3% rise.
Last year, RBS launched the Emerging Markets Autocall Accelerator, a fixed-term investment structure with exposure to the MSCI Emerging Markets Index. Similarly, Barclays Capital launched a product [the Emerging Markets Optimiser] with returns linked to the MSCI Emerging Markets Index Fund. Most recently, HSBC launched a series of exchange-traded funds in collaboration with MSCI. The launch was part of a rolling launch strategy which has been underway since August 2009. Deutsche Bank also issued Enhanced Participation Notes linked to the MSCI Emerging Markets Index Fund, with a two-year maturity.
A potential theme this year could be investors targeting developed market companies with significant links to emerging markets. "Market participants have expressed interest in indirect exposure to emerging markets," says Dimitris Melas, executive director at MSCI in London. "Trying to find ways of analysing how companies from developed markets will be able to profit from the increasing wealth and higher economic growth that is anticipated in their emerging counterparts will be important," says Melas.
Thirst for high yield
Asian markets continue to benefit from global liquidity flows as low interest rates elsewhere led to investors to search for growth opportunities. "There is a thirst for yield, there's not particularly high yield in developed countries," says Brian Coulton, emerging markets strategist at Legal and General Investment Management in London.
Vincent Berard, head of interest rates derivatives at BNP Paribas in Paris, agrees. "Investors are going after the returns, which are clearly higher than in the developed world and are also supported by the macro environment," he says. "There is a growing focus on rates and inflation investments in emerging markets." Berard predicts that emerging market currencies will appreciate relative to mature country currencies as their economies grow and incomes rise.
If interest rates are low investors get a relatively small yield in exchange for their cash, and if interest rates are higher they can achieve more. Interest rates differentials often drive foreign exchange markets, so in order to achieve high interest rates investors have to take risk on foreign exchange differentials at the same time to get higher returns. Forex derivatives, which account for half of all turnover in emerging markets, are used to hedge exchange rate risk.
"Emerging markets represent a growing share of hedging transactions," says Frederic Jeanperrin, global head of development, corporate derivatives sales at Société Générale in Paris. Emerging market currencies tend to appreciate relative to the US dollar in real terms, he adds. "We've seen more and more interest for emerging markets, mainly from corporates on the currency side, and linked to foreign direct investments and to the hedging of revenues generated in emerging market currencies," he says.
Source, a London-based ETF provider, launched a series of ETFs linked to Bric markets this year. "The largest emerging markets look particularly attractive," says Michael John Lytle, director at Source. "People start to recognise them as looking a lot like traditional developed economies as they have the depth and complexity that comes from full development.
"People are seeing that emerging markets countries have higher levels of growth, and at the same time their currencies are appreciating against the US dollar. So there is a benefit from both perspectives," says Lytle.
Liquidity remains a concern, however. "In Asia, for example, there probably isn't much scope for a desirable level of liquidity with the lack of bond issuance and difficulty in building two-way markets. The markets in South Africa and Israel are fairly liquid though," says BNP's Berard. Higher rates are now expected in countries that experienced relatively mild downturns, such as Israel, which was the first to break ranks when it raised rates, or those swept up by China's stimulus programme, such as Australia and South Korea.
"The concerns circulating around emerging markets are not about whether growth will continue, but rather how growth has been priced in," explains Source's Lytle. Product manufacturers have been raising issues on price/earnings multiples in stocks. "Does this mean that they have already priced in significant growth and development?" There have been a lot of banks bringing out individual country exposure but not raising assets, says Lytle. "Most investments have been predominantly around broad emerging markets exposure or Bric economies. The amount of money going into smaller, more exotic markets is significantly smaller."
Emerging markets therefore remain susceptible to below-cost-of-capital returns and bubbles in equity markets, real estate and other asset classes because of market valuations that exceed intrinsic value. Banks say that foreign investors will need to carefully assess valuations before committing their capital. "We don't expect any overly exotic payouts coming in emerging markets structures. What we do expect is banks to simplify underlyings, build newer propriety indexes, and newer risk management/volatility control overlays to fit with these indexes," says RBS's Chaudry.