Investment reports are designed to update investors each month, yet are often bland. Most times, this is just what investors want; brief comfort that their investments are making steady progress. But volatile markets demand more; not just handholding, but facts and honest appraisal. Investment managers’ behaviour in times of market stress can be revealing.
When times are tough, investors can learn more than usual about their fund managers. This year, emerging markets have proved an unusually testing environment. Investment reports should recognise that concern, offering facts and strategy rather than unchecked optimism. So what should investors make of the latest reports from their emerging markets managers?
Behavioural finance can help investors understand the psychology involved. Many of the fund reports are interesting examples of cognitive dissonance: a conflict between emotions and reason. So much emotion is tied up with the decision to back emerging markets, that new facts get little attention. The reality of many emerging markets has been changing this year, and the new environment should be reassessed. But, it is human nature to focus instead on collecting supporting information for a case.
Investment managers can be too ready to dismiss contradictory news. Much of current reporting by investment managers reveals an unshakeable confidence in the inevitability of long term reward. But, this year’s rough journey may have caught clients unprepared. Recent events challenge the growth arguments that have historically been put forward about emerging markets, and investors can only capture long term returns from equities if their overall portfolios are structured to handle the inevitable volatility.
There have been recurring crises in emerging markets over the past two decades. But current reports from many managers simply reiterate the mantra of faith in emerging markets: they are in this for the long term.
Investors are not invited to question the growth story, whatever the volatility or risk. This does investors a disservice, as they need to structure their overall portfolios to manage anxiety. The crisis in emerging markets, and sharply reduced growth forecasts, may point to necessary portfolio re-balancing.
Few reports point to any change managers are making in portfolio allocations, or directly address the issue of currency risks and capital controls. Many countries have now raised interest rates, imposed import controls, restricted capital movements in some way, or taken other action to defend currencies.
Foreign exchange reserves have weakened, and continued support via buying US Dollars is not a realistic option. The actual currency levels may simply have been too high, driven by capital inflows, and should not now be defended. Markets already caught up in this turmoil include India, Indonesia, Philippines, Malaysia, Turkey, Brazil and South Africa. Others may join this list if portfolio rebalancing by international investors accelerates.
It seems that the prospect of a squeeze in the supply of Dollars, traditionally providing cheap credit to many firms based in emerging markets, has sharply changed the outlook. And, for some nations, there has been insufficient transparency on genuine economic growth or productivity achievements.
Undoubtedly most of these nations are growing more rapidly than the mature nations of the West, but academic research shows little direct correlation between economic growth and investor returns in equities. (Editor’s note: This article addresses this relationship in more detail.)
The current problems may not be a simple re-run of the Asian financial crisis of 1997. Half a century ago the economist Charles P. Kindleberger outlined the potential for bubbles. When a country is “discovered” by international investors, it often attracts an avalanche of capital inflows. These not only raise the currency, but trigger a domestic boom. The higher exchange rate discourages exports, encouraging investors into non-tradable sectors. These areas, such as real estate, then enjoy a boom. The bubble ends when the capital flows reverse, but by then devaluation is needed to correct a trade deficit. It is rare for productivity gains to support the previous currency appreciation. This scenario looks familiar, yet rarely features in reports from emerging markets managers.
The emotional pain for investors is clear. Some managers have avoided providing recent benchmark comparisons or shedding much light on investor losses. Other investment updates talk about searching for bargains amidst the turmoil. Undoubtedly there will be opportunities to make portfolio switches, although there is little evidence so far of this happening. But, any suggestion that emerging market managers will be buying now, as others sell, begs the question of what cash is available to do this.
The larger emerging markets have seen steady outflows in recent weeks, and this reflects the portfolio rebalancing by institutional investors and some redemptions from emerging markets funds. The falls in emerging markets suggest that sellers are still in control, driven by concerned international investors. Periods of pessimism may indeed be the best times for investors to buy, but within funds that are already dedicated to emerging markets, selling may be needed to fund this.
When managers use phrases such as “I believe in the emerging markets’ comeback story” we can readily identify the emotion involved. Narratives like this can be shorthand for a lot of experience, but clients might like to know that a re-appraisal has been made, incorporating the new facts. Emerging markets might be the right long term investment, but investors need to know this is based on facts, analysis and judgement, rather than blind faith.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.