The first half of 2013 has shown that investors may be more resolute in their risk aversion than previously thought. At first, the markets seemed to shrug off continued concern about the Eurozone and volatility in both equity and bond markets. But by mid-year, the markets realized that a rising interest rate environment and a pullback of asset purchases by the Federal Reserve would soon be on the doorstep.
The first reaction to this news was large redemptions from both emerging markets and income-sensitive assets. While this may have been a short-term correction in asset prices, it could signal struggles ahead.
Still, there remains a bright spot in the gloomfrontier funds, featuring firms in markets that are just starting to emerge as international players (including Croatia, Vietnam and Bahrain). These funds are among the top performers of all non-domestic and U.S. equity funds since the start of 2013, based on a comparison of MSCI Indices (see chart).
These funds have done well because companies in these countries are still isolated enough from world events that they remain a relatively non-correlated asset class. That, combined with their economic growth potential supported by structural investment from outsiders, makes them a prime target for investors willing to take on the added risks. Many investors are also losing patience with traditional emerging markets. They want to get into frontier markets early to capitalize on expectations that they will move to emerging status within the global marketplace.
And while international funds are starting to show net outflows, the emerging markets funds segment, specifically mutual funds, continue to show resilience. In June alone, international equity funds experienced net outflows of roughly $5 billion. But in emerging markets equity mutual funds, investors bucked that trend and added over $1.6 billion.
From a long-term perspective, compared to where they started in 2009, international equity funds ex-U.S. are still tracking well ahead of U.S. diversified equity fundsthe staple of most investors' core equity allocations. U.S. stock funds had net outflows of roughly $155 billion since the beginning of 2009. (Global equity funds invest in both U.S. and non-U.S. stocks, while international equity funds focus primarily overseas.)
In comparison, between the end of 2008 and the end of 2012, non-U.S. funds attracted approximately $216 billion in net new cash. Of this amount, roughly $150 billion went into emerging markets equity funds. This shift has been in part driven by talk about how countries such as Brazil, Russia, India and China (BRIC) will be the future growth engines of the global economy. A majority of diversified emerging markets equity funds have over a third of their portfolios allocated to a combination of these markets.
Even with the renewed interest in domestic stocks thus far this year (with approximately $84.2 billion of net inflows through June), and the net outflow year-to-date from non-domestic funds in the aggregate, emerging and frontier funds continue to hold their own. So whyin a time of heightened risk awarenesshave fund investors continued to build their riskier, non-U.S. exposure?
Investors continue to invest in frontier and emerging markets equity funds because their fundamentals are still valid, albeit more risky. Traditionally, investors picked these products to diversify and gain exposure to a mix of asset classes that don't all react in the same manner to global market events. Investors also chose these funds because, in the long term, stock returns are linked to economic growth, and investors can take advantage of this growth by investing in regions with higher growth prospects.
The drop off in international equity fund flows is partially due to recent concerns over the possible tapering of quantitative easing efforts by the Federal Reserve, a move that has led to the unwinding of many risky bets in developing market securities. In addition, non-correlated exposure in international equities is getting harder to achieve. The integration of global economies, especially the globalization of financial markets, has created a scenario where equitiesregardless of their exposurereact similarly to a common source of risk. This has been especially true for equity markets across the globe as firms integrate their business models to better utilize the cross-border flows of goods and labor.
Over the long term, most of these regions have provided positive returns, but with the recent selloff in many developing markets (excluding frontier markets), most regions have ended the first half of 2013 well in the red. As the chart above shows, all variations of equity exposure looked great during the buildup to 2013, with emerging markets leading the charge. But all that changed in 2013. For long-term investors, this recent weakness is probably just a blip in cumulative return, but it may be a challenge to those who jumped in more recently. As mentioned earlier, frontier markets have weathered the selloff quite well and have provided the best returns thus far this year.
Outside of emerging markets, the remaining driver of net inflows to non-domestic equity funds has been diversified international index funds (+$86.1 billion net since the beginning of 2009). These products provide easy access to a diversified portfolio of international stocks. Although not the place to find triple-digit returns over four years, this diversification has provided steady returns. The MSCI EAFE index was up roughly 4% in the first half of this year. This index measures the equity market performance of developed markets, excluding the United States and Canada. If you are looking for added emerging-market exposure, but your clients aren't ready to take on the risk of frontier markets, products that benchmark to the MSCI All Country World Index (ACWI) ex-U.S. may be best.
Overall, U.S. investors have been increasing their ex-U.S. equity allocation to both increase equity diversification and take advantage of growth-driven gains. As with any situation where multiple funds are held within a portfolio, it is important to understand how those products work together. Do the holdings in an international index product overlap with an emerging-market fund or individual stocks? Is the overall international exposure overextended, especially when viewed in combination with stocks of U.S. companies that sell internationally focused products (roughly 44% of S&P 500 revenues now come from overseas)?
The trick is to manage this exposure in a smart way that does not increase risk-taking beyond an investor's tolerance. While investors have been forced to react to recent concerns overseas, the reality is that the United States is slowly losing market share in terms of growth. Investors will need diversification to non-domestic stocks if they hope to keep up with this shift in the global economy.
Matthew Lemieux is a senior research analyst for Lipper. He specializes in performance analysis, methodology management and fund flows and also contributes to Lipper FundFlows Insight Reports.