The Role of Emerging Market Institutional Investors in Emerging Market Equities

Financial globalisation has been associated with increasing emerging market (EM) investor diversification.^1&2 In recent years, the EM institutional investor (EMII) base, including pension funds, insurance companies, and mutual funds, has grown substantially in many EM countries. Specifically, total assets of EM pension funds have risen by more than 140% since 2000, driven by both rising asset prices and the growth of domestic pension systems (Figure 1). The strong growth of the EM mutual fund industry until the onset of the financial crisis has corresponded with rapidly increasing equity valuations, fast income growth, and the emergence of a growing middle class channeling some of its savings away from traditional bank deposits. In the short-term, there is likely to be a growth slow down of the EM mutual fund industry given the repercussions of the global financial crisis with EM equity markets across the world having sharply declined and GDP growth slowing as well.

Figure 1: Emerging Market Economy Assets

In recent years, countries such as Brazil, Korea, Malaysia, and Mexico have adopted legislation to build up their insurance and mutual fund sectors as well as domestic pension systems, while some have also eased domestic as well as outward investment limits by EMIIs. In addition, some EM sovereigns have set up new types of investment funds – often to complement their sovereign wealth funds – that actively invest in foreign assets in both advanced and other emerging markets, including equities. Despite its growth in recent years, the level of the EMII asset base remains relatively small compared to that of advanced economies, and it varies across countries and regions (Figure 2). For example, Turkey’s mutual fund industry and private pension funds are very small compared to some of their middle-income peers, with the majority of the free float on the stock market held by non-residents. The recent drastic withdrawal of foreign investors from EM markets has also affected Turkey. The relatively undeveloped state of Turkey’s non-bank financial sector may be partly due to past periods of macroeconomic volatility and high inflation. Recent legislation with regard to private pension funds and insurance led to some rapid growth of the local EMII asset base, albeit from a low level.

In contrast, South Africa has a thriving and large EMII base with the state-owned pension fund (Public Investment Corporation – PIC) – one of the largest in the world – being the biggest domestic equity holder, and with the insurance sector having the highest penetration (in terms of premia to GDP) among EMs. Similarly in Brazil, a large and diverse EMII base has contributed to the deepening of the financial market in recent years. However, compared to advanced economies, the asset allocation of pension funds and insurance companies in many EMs tends to include a higher proportion of government securities, in part due to government regulation. They also tend to be ‘buy-and-hold’ investors, which constrains the development of secondary market liquidity.

Figure 2: Pension Fund Assets in Selected Countries (2006)

Figure 3: Mutual Fund Assets in Selected Countries (2007)

Amplifiers or Not?

In principle, a diverse investor base – with regard to investment horizons and risk appetite – can contribute to financial stability, especially by spreading risks more widely. In practice, however, whether EMIIs are a stabilising factor moderating boom-and-bust cycles in equity markets depends on their asset allocation behaviour, which in turn is driven by their risk profile, investment horizon, liability profile, and constraints imposed by their governance and regulation.

The stable investment horizon and typically buy-and-hold behavior of pension funds and insurance companies can contribute to a financially stable base for domestic stock markets. These EMIIs are able to keep their asset allocations unchanged during market downturns or even go against market trends and may enhance the depth and breadth of equity markets. In addition, guided by their mandate, they pursue portfolio reallocations gradually, which can limit abrupt price movements. For example, in Korea, institutional investors’ stable funding to the market can act as a buffer against the reversal of foreign equity inflows, especially since they are highly domestically oriented in their portfolios. In South Africa, past periods of foreign exchange controls have created a large LII base – in particular the public pension fund PIC – which contributes to financial stability especially at times of high volatility in equity markets and abrupt capital movements. In addition, South African banks are less dependent on foreign liabilities and corporates are still limited in their asset allocation abroad due to capital restrictions.

Sovereign wealth funds (SWFs) typically invest most of their assets beyond their national borders, with a few exceptions where they are also active players in domestic financial markets. But during the recent equity market turmoil, some SWFs have increasingly invested domestically, e.g. in the Gulf, to support plunging prices. As long-term investors with no imminent call on their assets, and with mainly unleveraged positions, SWFs are able to sit out longer during market downturns or even go against market trends.

In some larger EM countries, foreign investors, including hedge funds, can contribute to equity price volatility, as observed during the recent EM equity market sell-off. Domestically active hedge funds, with their active investment style and high leverage, can potentially amplify the cycle’s peaks and troughs by joining the mainstream equity market during upturns and selling during downturns. Their behaviour is probably closer to that of global hedge funds rather than local pension funds, which have long time horizons. Therefore, if global hedge funds sell, it is possible to observe herding behaviour among local hedge funds, especially in Asia where many local hedge funds have been invested long-only and suffered greatly in recent months.

Relatedly, unlike pension funds and other long-term investors, both hedge funds and mutual funds are subject to redemption pressures, which could exacerbate market volatility and downturns if there are forced sales. Redemption pressures across hedge fund types have significantly increased since the summer. Prime brokers have also reduced the funding for leverage, and some hedge funds have already closed and returned investments to their clients. However, by diversifying and broadening the domestic investor base, domestic hedge funds may also help increase market efficiency by fostering price discovery and liquidity as well as deepening the domestic equity market.

In terms of country experiences, foreign investor sentiment dominates developments in the Turkish stock market, as recently observed, since free float holdings of local EMIIs are relatively small compared to those of non-residents. In the Brazilian equity market, one-third of the trading volume has been by foreign investors, and non-residents were the main players in the initial public offerings market until this segment dried up following the onset of the international financial turbulence. The sharp deterioration of foreign investors’ risk appetite in recent months and their subsequent retrenchment from all the major risky asset classes have significantly contributed to the dramatic equity market sell-out across EM countries.

Overall, the EMII base is expected to continue to grow in the long-run despite the current financial turbulences, benefiting from favorable GDP and export earnings growth and further enabling reforms and regulation, especially in the domestic pension systems and asset allocation liberalisation, leading to a larger investment share of EMIIs in emerging equities.

Conclusion

Emerging institutional investors with a long-term horizon can play a stabilising role in emerging equity markets, while herding behaviour among more active and short-term-oriented institutional investors could potentially exacerbate market volatility during a downturn or financial turmoil.³

The views expressed in this article are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the author.

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