A couple of weeks ago we were invited by BNY Mellon Depositary Receipts team to attend an interesting talk by Andrew Karolyi, Professor of Finance at Cornell University, who published a book last month entitled “Cracking the Emerging Markets Enigma”.
The book is intended to address the ongoing confusion around how we define emerging markets. Professor Karolyi stresses that much of the misunderstanding stems from an obsession with ‘growth’: a universal, ‘efficient’ model (which he proposes here) should take into account all relevant factors and provide a standardised evaluation of any market.
Professor Karolyi identifies six key areas which help us to classify individual markets both quantitatively and qualitatively:
1. Market capacity constraints (e.g. market cap to GDP ratio, bond market capitalisation)
2. Operational inefficiencies (e.g. commissions, taxes and costs, settlement cycles)
3. Foreign investability restrictions
4. Corporate opacity (e.g. governance and accounting standards)
5. Limits on legal protections (e.g. insider trading laws, self-dealing, directors’ rights)
6. Political instability
He then applies this six-pronged formula to 33 separate emerging markets, using regression analysis to assess the impact of each factor on foreign investment.
One of Professor Karolyi’s main frustrations is the need of the financial media to shoehorn all passing market trends into fixed, acronym-sized boxes. The most obvious example is the BRIC label, which may have made sense when it was coined by former Goldman Sachs economist Jim O’Neill in 2001, but has since lost all meaning given the wildly divergent paths of Brazil, Russia, India and China in the intervening years. A quick glance at the spiderweb diagrams below illustrate this point well:
To put this in context:
Professor Karolyi agrees that there are additional factors he does not take into account that fit somewhere into the six classification categories (e.g. freedom of the press, demography), but thinks the rating system provides a picture of each market which is as accurate, comprehensive and balanced as possible. He also accepts that there are a number of so-called ‘frontier’ markets for which there are simply not enough data to build an accurate model. This in itself tells a story about the quality of governance in these markets.
One of the research’s key findings is that only five out of 33 emerging markets (Israel, South Korea, Peru, South Africa and Taiwan) were overly favoured by global investors in 2012 relative to their respective weights in the MSCI ACWI (see chart below). The majority were proportionally underweight with Russia, India and China in particular standing out, the latter largely as a result of foreign investment restrictions.
Between 2012 and 2013, despite clear net outflows across the EM space (many of which have since been reversed), individual markets again defied prediction or pattern, further underlining the pitfalls of lumping such diverse and volatile markets together under an all-encompassing ‘emerging markets’ banner.
In order to get to the bottom of this apparent unpredictability, Professor Karolyi uses regression analysis to identify the main factors driving increased or reduced investment from amongst the six categories. The results, which are discussed in detail in the book, should be an eye-opener for companies in these markets, particularly those with a relaxed attitude towards corporate governance.
The search for a universal model, one which eschews labels and classifications and relies instead on standardised empirical data which tell a full and visual story (particularly in the murky world of emerging markets), should be commended. An HSBC advert currently doing the rounds reads “In the future, there will be no markets left waiting to emerge”. Until that happens, Professor Karolyi’s model provides a useful roadmap to growth and investability for emerging economies and a comprehensive checklist for investors looking across a number of increasingly diverse markets.