How much should institutional investors allocate to emerging market real estate and infrastructure? To answer, let’s first consider three challenges to conventional asset allocation.
Firstly, our simplistic view of risk is misleading. While banks and other intermediaries are concerned with short-term investment performance, and so also asset price volatility and liquidity, most savers and institutional investors have long duration liabilities, and are more concerned with avoiding large permanent loss. Yet, they have been bamboozled by distorted interpretations of risk and collective prejudice, also an agency and regulator problem. Twelve trillion dollars are invested in negative yielding bonds and trillions more into other developed market asset classes in bubble territory. Yet, however risky developed markets are, it is erroneously considered always riskier to invest in emerging markets.
‘Whilst banks and other intermediaries are concerned with short-term investment performance, and so also asset price volatility and liquidity, most savers and institutional investors have long duration liabilities, and are more concerned with avoiding large permanent loss’
Secondly, macroeconomic warnings are flashing red. Global monetary imbalances, dangerously high debt levels, excessive monetary emissions in the developed world, and bubbles in developed market currencies, stock markets and bonds, all add up to a world in which the greatest chance of sustaining the largest permanent losses are from doing the conventional: by concentrating a portfolio into liquid developed market assets.
Thirdly, we need to rethink liabilities. Savers ultimately want future purchasing power, not the proxy of nominal money payments. Ahead of regulatory change recognizing this, and in any event given fiduciary responsibilities, this should drive re-allocations now. In our globalized economy, emerging markets are price makers in more and more international goods. Thus, not investing in emerging markets is gambling away from liabilities. Retreating to domestic assets amounts to a concentrated bet, particularly in Western Europe, the US and Japan. Conservative does not mean prudent. Consider, for example, that we could easily tip into a 1970s-style high inflation environment.
How to rethink asset allocation
One way to use our knowledge of macroeconomic imbalances, politics, demographics and history is to use scenario planning. Top of the list of scenarios to consider, and have a response strategy for, is another global financial crisis – possibly much worse than 2008. Such a strategy should feature major allocations to non-levered economies, assets which are non-tradeable and otherwise relatively immune from external shocks, and illiquid assets least likely to face massive and correlated investor outflows in a crisis. Emerging market real estate and infrastructure meets all these requirements and can help to reduce risk away from currently highly concentrated allocations to developed markets.
It will vary considerably from investor to investor, but a rough benchmark could be 17 percent.
Typical investment indices are highly distorted and wholly unfit for determining global allocation weights. Purchasing power parity is arguably the best available long-term measure of global economic weights and hence the investment universe. Using PPP, emerging markets are currently about 58 percent of global GDP and are expected to grow to about 72-73 percent in 15 years, a typical institutional investor liability duration. However, not all goods are tradeable – those subject to international competition and price setting.
For a relatively open economy like the UK, 50 percent of exposure could remain domestic to cover liabilities not determined by global supply and demand. So that moves us from say a 36 percent to a 72 percent allocation to emerging markets. But that is a neutral weighting and does not compensate for the relative misconception of emerging versus developed market risk, and comes before making special allowances for high impact negative scenarios. You are also getting higher returns in emerging markets. Taking these into account would argue for pretty much the whole non-domestic exposure to be in emerging markets – let’s say 46 percent up from 36 percent – and more if the home economy is also in trouble like the UK. So that could, prudently, push us up to a 56 percent emerging market allocation.
The next question, within emerging markets is how much should be in real estate and infrastructure? Within developed markets, allocations to just real estate can be 15 percent, often more. Within emerging markets, we can double this to 30 percent given the scale of the opportunities relative to liquid markets – a far greater proportion of economic activity is unlisted in emerging markets – relative value, and the protective role we are seeking from illiquid assets given we want to avoid sudden major correlated losses. And 30 percent of 56 percent is our 17 percent.