Most fiduciary investors underweight emerging markets. This is because when they talk about an “investable” universe, they really mean whatever’s “easy to invest in”, argues Jerome Booth, head of research at Ashmore Investment Management. The recipient of China’s first post-Communist asset sale to a foreign investor, Booth recommends investors take the radical step of investing 50 per cent of their total portfolios into emerging markets, via both listed and unlisted markets.
He says: what investors want is future income, and arguably the best measure of that is past income, not public market capitalisation. The best global measure of past income is GDP. Emerging markets represent 50 per cent of global GDP using purchasing power parity, and are expected to reach 50 per cent using market prices within a decade – that is, less than the average liability duration of a pension fund. Hence there is an argument for a neutral 50 per cent allocation to emerging markets.
Though asset liability management has its place, nobody can accurately dynamically match assets to liabilities. Indeed, by overly concentrating portfolios in the attempt, tail risk is increased. The only free lunch in investing is diversification. So better to diversify fully in accordance with the widest spread of global investment opportunities “that is, according to GDP – and then partially hedge back to liabilities.
Also, most risks globally, especially the correlated risks of depression, are now in the developed world. Higher return growth is expected in the emerging world.
Why are we so far away from such an allocation? We use market cap not GDP weights. Market cap includes all the white elephant investments which were wasted as well as income-producing ones (remember dot com?). The volatility of multiples also demonstrates how bad a predictor market cap can be of future income. Indices are generally not only mostly market cap based, but cover only a fraction of the available investment opportunities. We abuse the English language when we refer to “investable” assets: we mean “easy to invest in”. If India has a wealth of investment opportunities in proportion to the size of its economy but a relatively small number of publicly listed instruments compared to the US, available indices under-weight India. The global investment industry surely can do a lot better in accessing difficult opportunities. Also, expect much faster market cap expansion in big emerging markets in the near future.
Also, risk (a forward looking concept) is often confused with recent past behaviour. At the outbreak of World War in 1914, sterling and even the French franc rallied, and the US dollar fell. Needless to say this condition did not last. It was a flight to liabilities, not to safety. Rushing to the familiar is not risk reduction. Watching this happen should not fool us otherwise.
There is also herding in the investment industry due to intellectual failure in our theories, failure adequately to analyse structural shifts, and misalignment of interests. If a group is standing on railway tracks with an oncoming train, closing one’s eyes is not the best choice. You may convince yourself that you have so far experienced no volatility: not good. That other people are also unmoved does not negate the danger. Depending on models of the past is no substitute for observation and thought.
Booth says: all countries are risky. Emerging markets are those where this risk is priced in Developed countries are where investors do not even perceive their own risk. Greece was given a licence to be fiscally irresponsible. Developed countries have built up excessive leverage after two to three decades of financial deepening which has not occurred in emerging markets. So I define emerging markets not by risk, but by risk perception.
It is not that emerging markets are not risky, but that developed countries are at significantly greater risk in the worst-case scenarios. Some of this can be described as core periphery disease: after several centuries of European/Western dominance of the globe, we consider the impact of the core on the periphery, but ignore the effect of the periphery on the core.
People – their “guts” if not their brains at least – associate “emerging” with risk. Yet think of two scenarios. In the benign one the US and Europe, with still several years of de-leveraging ahead, grow at an average of 2 per cent; compared to 7 per cent in emerging markets. In the 1930s Great Depression scenario, hundreds of thousands of companies go bust across Europe and the US at the same time. Emerging markets are definitely impacted negatively in a major way, with significant loss of export revenues in the short term at least. Growth could be reduced by a full two points to 5 per cent!
So why does a fiduciary investor have more than minimal investment in the US or Europe right now? Frankly I do not think they should. They need to have some international exposure because of their own home country’s macro-economic risks, as well as for diversification and return benefits. That argues for less than 100 per cent in domestic assets. It argues for up to 50 per cent across a range of emerging market asset classes.
Ashmore has long invested in every emerging markets asset class, in the belief that developing country stock markets can become too correlated to those of their developed market peers. On the private equity front, in 2006 it was part of a consortium which bought Asia Netcom, an owner of subsea cable networks in the region. The vendor was the Chinese Government-owned China Netcom, and according to Booth, the deal represented the first time the Communist regime had sold an asset to foreign interests.