Finnish pension funds are increasingly looking to up their exposure to emerging market debt. Keva, the Finnish Local Government Pension Fund, and the Finnish Central Church fund have already announced plans to increase not only their allocations to emerging market equities, but also to emerging market debt.

Timo Viherkenttä, deputy CEO of Keva, says that its push into emerging markets in 2009 has been “quite aggressive”. Its overall portfolio has about 11 per cent invested in emerging markets. The bulk of the investments is allocated to emerging market equities, but a considerable part is allocated to emerging market debt.

Other Finnish players are also considering expanding their allocations, as the prospects for growth in emerging markets are generally believed to be greater than those of developed markets, which will likely face significant structural changes in the coming years.

David Dowsett, senior portfolio manager for emerging market debt at BlueBay Asset Management, confirms this trend.

“From the third quarter of last year, we have observed an increased interest in this asset class,” he says.

He notes that the interest comes not only from those who want to increase existing allocations, but also from investors wanting to make their first allocations.

Tapiola’s investment director Hanna Hiidenpalo is attracted by the favourable ratio between cost and risk and, though she won’t be drawn on figures, she says that the company has plans to allocate “several hundred million euros” to emerging market debt over the short to medium term.

As most investors maintained their allocations even during the financial crisis, the nature of these investments seems to be changing.

“In the past, emerging market debt played an active, tactical role in our portfolio,” says Ms Hiidenpalo. “Nowadays, we see it as a strategic and integral part of our fixed income allocation.”

This is echoed by Mr Dowsett, who believes that an efficient frontier analysis of emerging market debt relative to other fixed income asset classes should point to a weighting of between 5 per cent and 10 per cent of fixed income.

“That’s a mathematically justifiable allocation that I think more people will move to,” he says.

The Finnish solvency mechanism is also a factor, as – unlike with debt – upping one’s allocation to equities requires an increase in buffers. Many Finnish funds have already allocated at least 30-35 per cent of assets to equities and are reluctant to increase this further. Adding risk via fixed income could make more sense.

Not all investors will be rushing into emerging market debt, however, with some preferring to derive their emerging market risk through what they see as the more liquid characteristics of equity.

“We fear that the withdrawal of quantitative easing programmes and potential rises in interest rates may not proceed as orderly as we’d like,” says Wilhelm Backlund, director of fixed income, currency and commodities at Finnish pension company Varma. “We are uncertain of what impact this will have on fixed income markets and therefore would like to stay as liquid as we can.”

Varma must also consider the regulatory framework, which dictates it set aside more capital for investments outside the OECD area, whether for equities or debt.

“From that perspective we feel it is more cost effective to take our emerging market risk in equity form,” says Mr Backlund.

But whether emerging market equities truly offer more liquidity than debt is not something that is universally accepted. Mr Dowsett feels that liquidity in emerging market debt could be at least equal – and possibly greater – than that of emerging market equity.

“These are very sizeable markets that are growing quickly, and in which local investors are themselves actively invested,” he says.

“This means that the transaction size that you can get done within emerging market debt is significant. In the sovereign spaces of both hard and local currency debt, I think that liquidity within fixed income is at least competitive to that within emerging market equity.”

One other factor that makes a long-term allocation to emerging market debt attractive is its relatively low historical volatility.

“Of course it hasn’t had the 80 per cent up years that emerging market equities have had, but it hasn’t had the catastrophic down years either,” Mr Dowsett says.

“This could attract people who want exposure to the emerging market story, but also want to somewhat limit their downside.”