Cash-rich global pension funds are starting to increase their miniscule emerging market allocations, raising the prospect of a rapid acceleration in flows that could swamp the relatively small asset class.
Retirement funds in the world's 13 biggest pension markets hold assets of around $26 trillion - almost 10 times the value of MSCI's emerging stock index and three times the entire stock of emerging local currency debt in the world.
So far, little of that huge cash stock has come to emerging markets. Fund managers estimate allocations at 5 percent, making them grossly underweight a sector that comprises almost half of the world economy and 13 percent of global stock indices.
"There are very few pension funds world-wide that have more than 5 percent of their assets in emerging markets. If anyone has 20 percent they would be an outlier," said Julian Mayo, portfolio manager at Charlemagne Capital.
"But our impression is there is definitely a gradual increase in exposure to the aasset class by pension funds. That is borne out by a recent torrent of new emerging market mandates from pension funds, including $400 million awarded by US giant CalPERS. Similarly, the UK's 31 billion-pound USS pension fund said it would pump 320 million pounds into emerging equities, taking its weighting to 7.5 percent from 5 percent.
And CalPERS may have doubled its EM equity investments since 2007. Though that has still only taken its allocation to $5.2 billion or 2 percent of its $238 billion asset base, showing how under-invested pension funds are in emerging markets.
So by all accounts, large institutional flows are poised to join the developing asset class, potentially providing a strong boost to markets. Moreover they are just the kind of sticky, long-term investments emerging governments crave. But it means developing nations must step up stock and bond issuance or risk the destabilising consequences of having too much investor cash chasing too little market cap.
To put that in perspective, a 1 percent allocation swing by the $26 trillion industry would bring in $260 billion or almost 10 percent of the existing market cap of the MSCI emerging index, a disparity in size that Bank of England economist Andrew Haldane likens to a "BFSP problem," or big fish in a small pond. What pension funds have is a home bias, focusing investments at domestic or developed markets. But this bias is eroding.
Haldane calculates that a 0.1 fall in a weighted home bias index for developed countries would equate to a $4.5 trillion portfolio swing, with bias measured on a zero to one index.
Bursting financial asset bubbles would have big economic repercussions. They also risk a return to the old boom-bust cycles that made emerging markets a byword for high-risk investment through most of the 20th century - the very factors that have kept pension funds wary of them until now. Developing countries, aware of these risks, are engaged in what Haldane calls a "footrace" as they try to expand supply of investable securities to keep up with surging investor flows.
Total EM equity capitalisation will rise to $37 trillion by 2020 from $14 trillion now, while the emerging market share of world indices will rise to 19 percent from 13 percent, Goldman Sachs has predicted. But western investors will also up EM equities to 18 percent of total investments by 2030 from under 6 percent now, GS added.
The main factor forcing Western pension money into EM is the worsening asset-liability mismatch as poor investment returns in recent years fail to meet the needs of ageing populations.
Pension strategies tend to be liability-driven, meaning they must match asset allocation with current and future liabilities. In the United States for instance, the Pew Centre, a Washington-based think tank, estimated the states' pension system is over $600 billion short for future benefit payments.
The US states had assumed 8 percent annual investment returns, twice what was achieved from 2000 to 2009, it added. Emerging investments have the potential to fill these gaps - MSCI emerging equities have returned 30 percent in dollar terms since 2006 while developed equities have lost 7 percent.