The Great Mismatch: Addressing Barriers to Global Capital Flows (Part V)
Click to Print This Page
PART V: Ideas for Navigating Capital Flows
To succeed in the evolving global capital landscape, long-term institutional investors will need to be at the forefront of re-thinking long-standing assumptions and re-shaping markets. Enough success factors have already been identified to serve as a rough guide for investors to navigate the growing opportunities in emerging markets, while mitigating risks, in both the near term and beyond. (See Exhibit below.)
Today’s debates about capital flows differ in an important way from those of a generation ago, says Prudential Fixed Income’s Odenius: Today’s relationship between emerging and developed markets is much more complex. Years ago, emerging markets were bystanders in policy debates getting “crumbs left on the table” of policy consequences decided in the developed world. This is no longer the case, as is shown, for example, by the impact of the developed world’s quantitative easing programs.
“It’s a lot more interactive and a lot more codependent [today],” Odenius says. “Previously, seen from a developed-market perspective, it was good if the emerging markets were running good policies, of course. But now you have to concern yourself with the question of how the emerging markets set policy in response to central bank policy in the U.S., in Europe, and in Japan.”
RE-THINKING THE USE OF BENCHMARKS
To adapt to this new interactive world of capital flows, it is crucial to recognize and change mindsets that exist today. “There’s a tremendous amount of conservatism, in the bad sense,” says Prudential Fixed Income’s Rajan. “And it comes from not wanting to be the one who is the first to go out there to do something that is out of the ordinary. And it manifests itself through the indexing process and the standard asset allocation process. ”
For example, many investment managers look at asset class sizes to determine allocations. As noted earlier, markets in the developed world are much bigger than they are in emerging markets. “So if you make allocations based on the size of the markets,” Rajan says, “you’ll under-allocate to [emerging markets]—the place that has the best growth potential.”
The Barclays Global Aggregate Bond Index gives disproportionate weight to developed nations—the U.S. alone accounts for 42% of it. Meanwhile, it has an attribution weight for non-China emerging markets of about 8%, plus China at 1.1%, for a total for emerging markets of only 9.1%, which is very low by economic metrics, such as share of global GDP, demonstrating a bias against emerging markets.
This kind of contra-growth assessment is not the only consequence of an investment outlook that depends too much on the status quo. These benchmarks also over-allocate to over-indebted and over-priced debt markets and countries, many of which are in the developed world, Rajan says. He notes that such benchmarks “have become an albatross that the entire industry has to carry.” The recent yield on Japanese government 10-year bonds is one-half of 1%. “We’d rather lend to an emerging country at 5% when we’ve made sure that it has a sustainable debt-to-GDP ratio and a positive trajectory,” Rajan says. “But if a client comes in with a benchmark that has 20% Japanese bonds and they tell us ‘Don’t depart from this by more than five,’ we have no choice.”
Yields are higher in emerging-market bonds, and governments there often carry much less debt. “So it really makes one scratch one’s head when you think about how so many actors in the investment community are committed, even for the long term, in poorly constructed benchmarks,” Rajan says.
MOVING BEYOND THE NATION STATE AS THE UNIT OF ANALYSIS
In order to categorize investments in a more accurate way, it might be useful to stop using “region” or “nation” as the basis; there are circumstances where investments should be classified differently to produce a better analysis, and thus, better results, Wharton’s Nair says.
For example, “when thinking in terms of categories, where the categories are not defined by regions but are defined by risk premium—whether you think of it as yield, value, momentum, liquidity—those drive flows. So if there’s a high demand on flows on yield, then within some emerging markets, some instruments look pretty aggressively priced,” Nair says. “But if people don’t want to take liquidity risk, some other instruments look differently priced.
So when you start thinking in terms of where are people allocating capital, to which category are they allocating capital, and put on the lens of risk premium, it starts making more sense than if you worked with ad hoc political or non-economic categories.”
Similarly, “emerging market” itself may be a concept that is insufficiently precise to distinguish worthwhile investments from those that will not perform as well. Descriptions need to be more differentiated— moving the paradigm from investing in a particular country to investing in a particular industry, or, in the case of real estate and infrastructure, a particular portfolio of cities—because of the underlying growth prospects.
For now, though, in holding on to traditional mindsets, many investors are failing to assess opportunities correctly when they lump all emerging markets together, rather than evaluating and pricing risks according to relevant local-market conditions. For example, Nair says, “there’s no reason to think that when there’s a protest in Turkey, India’s going through issues. So you can construct portfolios that have enough of different emerging markets [to protect against excess risk], but the overall perception of Turkey’s protest affecting the entire emerging-market basket cannot be diversified away. So that’s where all the spillover effects of risk aversion show up. But the reality of that risk may be diversifiable.”
A general wariness of all emerging markets may be the reason there is now a potential bubble in what are considered to be safe assets—often U.S. and other developed-market assets. These are relatively expensive, due to a widespread sentiment around the world that savings have few other safe places to go.
LOOKING BEYOND OUR OWN BORDERS
A less subtle form of this kind of excess wariness in investment is “home country bias”—the preference for investments on one’s own turf, which many investment advisors see as irrational.
“In an ideal world, each investor would hold the same portfolio,” says QMA’s Keon. “Why should Belgian investors hold 80% of their assets in Belgium? In the long run, that’s sub-optimal.” More accurate assessments of investment opportunities should reduce this bias, he says. But it is unlikely to disappear completely, because it is based on practical considerations, not prejudice.
It is natural, he says, for investors to “feel more comfortable owning stuff [they] can see.” Moreover, he says, currency fluctuations can make home country investments less risky. “If your obligations come in dollars, holding a dollar-denominated portfolio makes a lot of sense.”
At the end of the day, most investors are reluctant to break away from their routines. Escaping this trap will require leadership. Those who are first to take the right steps will be rewarded by good returns, Rajan predicts.
For now, pension funds in the U.S. and Europe are still hugely under-allocated to emerging markets. “There is an information barrier. When you’re in the realm of the new, you need leadership to create new practices,” says Rajan. “And of course there’s always a bleeding edge. But while there’s a bleeding edge on the risk side, there’s a leading edge on the returns side. Technology keeps lowering those information barriers, so somebody can and will lead the change.”
This report was jointly produced by Prudential Investment Management (PIM) and Knowledge@Wharton, the online research journal of the Wharton School of the University of Pennsylvania.
The paper was researched and written with the close cooperation of investment professionals within the investment businesses of PIM, and scholars and practitioners affiliated with Wharton. The primary interviewees include:
- Franklin Allen, professor of finance and economics, The Wharton School (currently on leave at Imperial College London)
- Mauro Guillén, professor of international management and director of the Joseph H. Lauder Institute of Management and International Studies, The Wharton School
- Edward F. Keon Jr., managing director and portfolio manager, QMA, a business of Prudential Investment Management
- Joshua Livnat, managing director and senior researcher, QMA, a business of Prudential Investment Management
- Vinay Nair, visiting professor, The Wharton School, and founding principal, Ada Investments
- Jürgen Odenius, managing director, chief economist and head of Global Macroeconomic Research, Prudential Fixed Income
- Arvind Rajan, managing director and international chief investment officer, Prudential Fixed Income
- Michael Schlachter, managing director and head of Multi-Asset Class Solutions, Prudential Investment Management
The full report is available for download here.
 The Wealth of Cities, http://wealthofcities.prudential.com/