14th October 2013
Ashmore head of research Jan Dehn has kept up his stinging critique of the failure of the conventional investment approach to emerging markets.
He has slated an over-reliance on passive investment and badly done research from ratings agencies and investment banks and blamed it for a huge misallocation of resources to developed markets over emerging markets and within emerging markets.
In a note issued this week, Dehn argues that there is a major adverse selection in global asset allocations.
“We believe there are major adverse selection problems in global asset allocation. Adverse selection is the tendency for asset allocators to ‘select’ sub-optimal or ‘adverse’ investments at the expense of better alternatives”.
He says for this to happen two conditions must apply –
1) There must be differences in the quality of issuers
2) Investors must possess less information about the quality of issuers than the issuers themselves. The technical term used to describe this state of affairs is asymmetric information
The note continues: “The under-allocation of capital to emerging markets is made worse by conventional asset management practices. Sovereign research in emerging markets is generally very poor. Passive management is widespread.
“Many investors simply do not take credit research seriously, do not want to pay for it, and opt instead to rely on ratings agencies and investment bank research both of which can be seriously flawed.
“To make matters worse, the use of price volatility as a proxy for the riskiness entirely fails to safeguard portfolios. Volatility is a terrible measure of risk if markets are inefficient, which they self-evidently are. Risk is large permanent loss; volatility is merely a measure of up and downward movement of prices.”
Dehn also suggests that inflation is not a significant risk to these markets.
“Inflation has remained elusive across EM despite widespread currency weakness and relatively low policy rates in many countries. The reason, in our view, is that the global environment is fundamentally deflationary for EM. Why? Because it is characterised by high levels of risk aversion, strong preferences for allocating to ‘risk free’ developed markets, fear of currency volatility in less liquid EM markets, and generally tighter financial conditions due in part to regulatory biases against EM.”
He also says that Eastern Europe remains the most vulnerable regions partly because these countries started to believe they were ‘risk free’ developed markets which could borrow recklessly.
“Several Eastern European countries came close to believing themselves to be ‘developed’, that is, ‘risk free’ before 2008/2009. Based on this illusion these countries gorged on cheap credit, and several are still struggling with the consequences. For example, this week it became clear that, due to its current and past fiscal profligacy, Serbia will probably need to turn to the IMF for support. These days it is very rare indeed that EM countries need IMF support. In fact, EM countries are more likely to fund the IMF than the other way around. Other countries in the EMEA region that also face debt-related challenges include Hungary (household debt), Ukraine and Croatia.”