Endowments in Hotel California

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Three years of relentless underperformance by emerging markets has left many institutions grappling with an uncomfortable question: How long can we afford to be wrong?

Endowments bought into the narrative of massive, burgeoning middle classes in high-growth economies more aggressively than their pension and sovereign wealth peers. Even skeptics of the strategy acknowledge that the prediction may well come to pass. But for asset owners with even the longest horizons, the waiting period has been painful. Since April 2011, the iShares MSCI emerging markets index has fallen 17%, while the S&P 500 has gained more than 41%.

In the Harvard Management Company’s last three annual reports, remarks about the asset class read like Groundhog Day: “Although emerging economies broadly showed signs of cooling… our confidence in this area is still high” (2011); “Emerging markets equities lagged… but we remain convinced” (2012); “Emerging markets underperformed expectations… Notwithstanding, we remain convinced that, over time, the area will deliver strong positive returns for a portfolio like ours that can withstand short-term volatility” (2013).

Prolonged underperformance has left many CIOs with intense questions from their boards—and a major strategic choice: to hold, fold, dial back, or (theoretically) double down. Harvard has taken the first tack, with its allocation target remaining steady at around 11% of its $33 billion fund. The $700 million William & Mary Investment Trust, in contrast, lost patience with many of its worst-performing emerging markets managers last year and pulled its capital. Princeton University’s $18 billion endowment folded on its strategy before even implementing: Princeton upped its policy target for the asset class from 9% to 11% in 2011, but has been aggressively underweight since.

Sam Gallo, CIO of the University System of Maryland Foundation (USM), and his team were among those who chose to dial back emerging markets exposure. In mid-2013, the $1.1 billion endowment redeemed some of its investments from a number of managers in developing and emerging regions. Faced with a volatile and uncertain market, Gallo says, “We sized down to have clarity. It freed us from feeling any pressure to defend any single position. If you didn’t take some chips off the table, and you’re now fully invested, you need this trade to work.”

The phenomenon of falling in love with one’s investments has long been recognized by investors themselves, and more recently in behavioral research and neuroeconomics. The brain’s “extraordinarily powerful” circuit governing attachment invites cognitive biases into investment decisions, according to a 2010 paper. “The key is exposure,” write Paul Zak and Steven Sapra. “If we are around anyone or anything long enough, we develop either an aversion or an attachment to him/her/it.” Investors’ attachment circuits often target their portfolios, according to the authors, clouding decision-making around trading. “Your portfolio does not love you, and you should not be too attached to it,” they write. “Recognizing this bias is the first step.”

In the spring of 2013, the USM Foundation’s concentrated emerging markets managers were posting nice gains as the space crumbled. But Gallo pulled some of the assets, giving his team and the portfolio critical distance from the wayward sector. The returns potentially sacrificed by cashing out—the opportunity cost—struck Gallo as well worth it. “If you truly believe this is a 10- to 20-year story, sizing down for six or eight months gives us clarity and the edge for upcoming repositioning.”

Gallo wasn’t alone in uncertainty. Among major asset managers’ outlooks for 2014, emerging markets provoked the most disagreement and least conviction. Persistent volatility with no growth through the first quarter has narrowed the range of manager opinion: Almost no one is urging institutions to buy big anymore.

“Clearly, if you held a big allocation, the last 18 months have been a tough period in relative terms,” says John Chisholm, CIO of Acadian Asset Management. “It would have hurt. But today, we believe emerging markets are attractively priced relative to developed, and we’re not reducing our allocations.” Chisholm, like Gallo, suggests holding steady for institutions roughed up by the last few years. Slowing growth in China, benign commodity prices, and political upheaval from Turkey to Thailand temper his outlook, but, he says: “The odds favor being overweight today.”

That’s the bullish view. Paul Wong sees the odds in reverse: Reduced valuations hardly offset the risk of China’s credit unwinding, its trade partners suffering, a strengthening US dollar pushing up the cost of debt, and stagflation setting in. Wong, a self-confessed prop trader at heart, manages a short book for several hedge funds within Toronto-based Sprott Asset Management. Emerging markets feature prominently. “These economies had 10 years of wild capital inflow,” Wong says. “Now, as money flows out, it’s becoming clear how trapped some of those assets are in emerging markets. They’re Hotel California.”