Cracking the EmergingMarkets Enigma

Andrew KarolyiProfessor of Finance & Alumni Professor of Asset Management, Cornell University

Third Luxembourg Asset Management Conference, November 17, 2014

I. The Phenomenon: EMs in 2013

2013: A Tough Year for EMs

MSCI World

MSCI Emerging Markets

Sliding BRICS in May & June

Bank for International Settlements Quarterly Review

What happened in May & June?

“Normalize”?

And the Taper Tantrums Began!

“We hope that the issuing country of the largest reserve currency in the world should be mindful of the spillover effects of its macroeconomic policies.” Zhu Guangyao, China’s Deputy Finance Minister

China Daily, September 6, 2013

EM outflows continue in 2014…

…and so do the Taper Tantrums

“… a lack of a coordinated exit from exceptionally loose monetary policies was done at the expense of emerging markets.” Alexandre Tombini, Governorof Central Bank of Brazil

“International monetary cooperationhas broken down…Industrial countries have to play a part in restoring that [co-operation], and they can’t at this point wash their hands off and say, we’ll do what we need to and you do the adjustment.” RBI Governor Raghu Rajan

Different countries hit differently?

?

So what do we have?

• Some Observations:– The tapering talk had a sharp negative impact

on emerging markets– It was surprisingly large– Different countries were affected differently

• Some Questions:– Which were hit hardest by Fed’s taper talk? – Why these and not others? – Is it related to “fundamentals”? Which ones?

II. A (biased) perspective on the EM Experience

in 2013

Forthcoming Oxford University Press, May 2015

What is the new book about?

• I develop a rigorous, comprehensive, and practical framework to measure the fundamental risks associated with investing in emerging markets:– Rigorous. Foundation of sound academic research at its core.– Comprehensive. Multiple dimensions of risks reflecting the

uneven quality of institutions that assure integrity of markets.– Practical. I devise a scoring system that ranks EMs on each

dimension of risk using principal component analysis (PCA).

• I build the indicators for 33 EMs plus 24 developed using publicly-available data sources and show they work very well in explaining foreign investor cross-country holdings

Why bother writing it?• To elevate the quality of the discourse in industry

circles about what an emerging market really is• Answer? Page 1, first sentence:

“Underfunded growth opportunities with problems”

• Why bother?– Refocus attention: NOT JUST the growth potential– Emphasize multiple dimensions of risk that can matter– Stop with the endless race to coin a new acronym!

(BRIC, BRICS, N-11, TIMPS, CIVETS, MINT, etc.)– Useful to explain how investors think based on actions?– Academics? A useful summary of our collective wisdom?

What are my risk indicators?

• Market Capacity Constraints

– Market cap to GDP– GDP per capita– Private/public bond market

capitalization– Turnover ratios– New issues to GDP• Operational

Inefficiencies– Brokerage commissions,

transfer taxes, market impact costs

– Illiquidity proxies– Short-sales constraints– Settlement cycles (T+N),

book-entry, delivery vs. payment (DVP)

• Foreign Investability Restrictions

– S&P/IFC accessibility– Registration rules,

ownership restrictions, FX convertibility limits

– Withholding taxes, double taxation treaties

• Corporate Opacity– Governance rankings– Accounting standards– Earnings management– Blockholder control– Closely-held shares

• Limits on Legal Protections– Anti-self-dealing– Anti-director rights– Creditor info, registry– Director liability, shareholder suits,

contract enforcement – Insider trading laws

• Political Instability– Political constraints (PolConV,

PolityIV, DPI) – Voice & Accountability, Govt.

Effectiveness, Rule of Law, Regulatory Burden

– Transparency International’s Corruption

– Heritage Foundation’s Freedom Index

How do I build them?

• Step 1: Harvest the wisdom of academic research– For example: Lots of research on market microstructure

around the world for “Operational inefficiencies”

• Step 2: Combine with other useful data

• Step 3: Synthesize into single risk index with PCA

How do I build them?

PCA for Operational Inefficiencies

???

How is the book organized?

• Part I. Setting the Stage:– Accepting the challenge– Defining my EM universe– A Primer on PCA methodology

• Part II. Building the EM Risk Indicators• Part III. Validating the EM Risk Indicators

– I conduct three experiments

• Part IV. Conclusions and Caveats

How do the indicators look?

Market Capacity Constraints

Operational Inefficiencies

Foreign Accessibility Restrictions

Corporate Opacity

Limits to Legal Protections

Political Instability

-1.0

0.0

1.0

Emerging Markets Developed Markets

How do the indicators look?

How do the EMs rank overall?

They can evolve over time

Validating EM Indicators: Part I

• In Part III of the book, I test whether the six risk indicators can “explain” foreign portfolio holdings in 2012:– FactSet (formerly Lionshares), global institutional;

over $23.6 trillion AUM, $6.3 trillion is foreign only– U.S. Treasury International Capital (TIC), U.S.

residents only, retail and institutional, $7.9 trillion

• Focus is on excess holdings relative to MSCI ACWI weights to capture potential “biases”

Biases in Foreign Holdings

China Russia

Taiwan

Israel

India

Indonesia

South Africa

Turkey

Argentina

Chile

ColombiaEgyp

tIndia

Israel

South Kore

a

Mexic

o

Nigeria Peru

Poland

Saudi A

rabia

Slove

nia

Sri La

nka

Thailand

Venezuela

-10%

-5%

0%

5%

10%

15%

BrazilChina

-18.72%Israel

Korea

South Africa

Taiwan

Actu

al F

racti

on o

f For

eign

Equ

ity H

oldi

ngs

Less

Fr

actio

n of

Wor

ld M

arke

t Cap

italiz

ation

in 2

012

U.S. residents invest $1.01 trillion in 2012

Regression Evidence

A 1σ increase in quality of corporate governance – from Philippines to South Africa – is associated with 0.98% increase (decrease) in over (under) weight

What about Luxembourg?

A Quasi-Natural Experiment?

• What about “taper talk” and EM portfolio flows in 2013?

• Are they linked empirically to the cross-country differences in fundamental risks?

• An out-of-sample experiment? (Chapter 11)

Validating EM Indicators Part II:2013 EM portfolio flows

Arge

ntina

Braz

ilCh

ileCh

ina

Colo

mbi

aCz

ech

Egyp

tH

unga

ryIn

dia

Indo

nesia

Isra

elKo

rea

Mal

aysia

Mex

ico

Mor

occo

Paki

stan

Peru

Phili

ppin

esPo

land

Russ

iaSo

uth

Afric

aTa

iwan

Thai

land

Turk

eyVe

nezu

ela

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Net

Flo

ws o

f For

eign

Deb

t & E

quity

in 2

013

as %

of T

otal

For

eign

Hol

ding

s in

2012

Lots of cross-country variation!

U.S. Residents Only

What about 2013 EM flows?

A 1σ increase in limits to legal protections – from Argentina to Korea – is associated with 0.72% higher inflows (lower outflows) in

2013 as a % of 2012 holdings

III. Newer Evidence from EM Mutual Funds in 2013

A new study (in the works)

• “Racing to the Exit: Emerging Market Mutual Funds during the Fed Taper Talk of 2013” by Andrew Karolyi and Kirsty McLaren (PhD, Judge Business School, Cambridge University)

• Who? 312 active EM mutual funds with Morningstar individual holdings through 6/30/13, $318 billion AUM

• What? We compute their country-level active bets (Cremers-Petajisto, 2009) and flow-induced fund allocations (Jotikasthira, Lundblad, Ramadorai, 2012)

• Why? Which funds made big bets? Which direction? What fund attributes matter? What country attributes?

The GEM Fund Sample

Overall Small Adjustments…

…but lots of variation in active bets

-20 -18 -16 -14 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 200

10

20

30

40

50

60

70

80

90

Change in Country-level Active Share

Freq

uenc

y (o

ut o

f 312

GEM

Mut

ual F

unds

)

ΔActive Share

…And especially their timing bets

-50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 >500

10

20

30

40

50

60

70

Country-level Market Timing

Freq

uenc

y (3

12 A

ctive

GEM

Mut

ual F

unds

)

Market Timing

Which EM funds are these?!?

Which funds timed their EM bets?Market Timing

Which GEM mutual funds strategically timed the markets?• Smaller funds in total net assets!• Funds that had stronger returns leading up to taper talk !!!!

Next question: Which EMs were focus of “market timers”?

FIFAs versus Risk Factors

-0.12% -0.10% -0.08% -0.06% -0.04% -0.02% 0.00% 0.02% 0.04% 0.06%

-0.03%

-0.02%

-0.01%

0.00%

0.01%

0.02%

0.03%

0.04%

0.05%

0.06%

Hungary

Mexico

Nigeria

f(x) = 0.335315949468257 x + 4.71053572292871E-05R² = 0.335315949468256

Actual FIFA (May-June 2013)

Expe

cted

FIF

A (b

ased

on

Risk

Fac

tors

)

Emerging Market Enigma Cracked?

• Hardly!

• And 2013 is a useful quasi-natural experiment to evaluate what institutional attributes of EMs really matter to global investors

• “Softer” constraints like corporate opacity, limits on legal protections, political instability seem to matter more than “basic” risks like operational costs, market capacity constraints, foreign restrictions

• Stay tuned – lots more to come