Practical analysis for investment professionals
10 February 2015

Where to Invest in Emerging Markets: Lessons from the Taper Tantrum

Emerging market investing offers great potential and yet is not without its risks, as was clearly demonstrated by the “taper tantrum” in 2013–14. So how can investors attain the best of both worlds, reaping the benefits while containing the downside? A new book, Cracking the Emerging Markets Enigma, by Cornell University professor Andrew Karolyi (forthcoming from Oxford University Press) seems to have revealed some of the answers.

The book details the results of a research project Karolyi has worked on since 2005, backed by data from 2000 to 2010 and existing academic literature. I spent a few days over the past couple of weeks reading a pre-print copy that Karolyi kindly shared with us. Below are my takeaways on a few issues that I feel are particularly relevant for practitioners. (For background, please reference my earlier post in this series, “Have Emerging Markets Emerged?”)

Not all emerging markets are created equal.

Karolyi created a risk index composed of six dimensions mostly related to market institutions: market capacity constraints, operational inefficiencies, foreign investability restrictions, the quality of legal protections for minority investors, corporate governance, and disclosure issues.

It is clear from an examination of the rankings of all markets included in the study that emerging markets rank less favorably than developed markets along these dimensions. There is also considerable disparity from one emerging market to another.

For example, political instability is a dimension that Karolyi’s research found to have mattered both under “normal” market conditions over long periods of time and during crises. Specifically, the markets deemed less politically stable were underweighted more over the last decade, and a higher percentage of capital exited these markets during the taper tantrum. (See the table below for more details on what contributes to political instability in Karolyi’s framework and the indices he relied on to measure it.)


Measures of Political Instability


On a scale of -2.5 to 1.5, the median developed market scored close to 1 on this index in 2012. The 33 emerging markets scored from below -2, in the case of Venezuela, to a few slightly above zero, such as Chile, Poland, and South Korea — but all below the developed market median. So indeed there is a wide spectrum of distribution in terms of political stability across the 33 emerging markets.

Factors that matter in normal times are not always the same as those that matter during crises.

Not only has the overall risk index Karolyi created proven to be relevant (or statistically significant for those quantitatively oriented), five of the six dimensions highlighted in his research also worked individually. Interestingly enough, some work better under normal market conditions, others in crises.

Corporate opacity is the most important factor explaining decisions by both global institutional investors and US residents to overweight or underweight a certain foreign country’s equities. In both cases, the allocations ranged from an underweight of 2.5% of the respective market’s total market capitalization to an overweight of about 1%. An improvement of corporate capacity by one unit on a scale of -2 to 2 corresponds to an increase in allocation of 1.09% of their respective market capitalization in 2012. However, each unit improvement in the factor only explained 0.34% less net outflows in the taper tantrum of 2013, and it was only marginally significant individually.

Market capacity constraints followed a similar pattern.

In terms of explaining the outflows of 2013, limits to legal protections and operational efficiencies have turned out to have worked far better. Political instability is the only factor that worked well in both scenarios.

These results can be quite important to investors interested in emerging markets. They also seem to make intuitive sense. When investors enter a market, the size of the market and availability of information to enable securities research are certainly more important. When investors run for the exit, it also makes sense to first get out of markets that are tougher to get out of and offer less protection to minority shareholders. And all the worry about political instability in emerging markets seems real — the results indeed show that it is on the minds of investors both when they enter an emerging market and when they exit.

Investors in emerging markets apparently have a very different perspective.

This is a somewhat surprising and yet highly important finding of the research project. All the implications discussed above were demonstrated using either global or US data. When you try to explain the decisions of emerging markets institutional investors to overweight or underweight foreign equities, all these factors lose their explanatory power.

We have been saying emerging markets are “emerging” because their market institutions are not as sophisticated as those in developed markets. This new piece of information adds a significant twist to that interpretation: It appears that emerging markets are “emerging” because institutional investors in the developed countries are not yet comfortable with the level of sophistication in their markets. The book does not, however, provide a conclusive answer as to why emerging markets institutional investors exhibit this discomfort.

If this true, then it is a moot point to argue whether the taper tantrum properly reflects economic fundamentals in the emerging markets.

Overall, I think the framework Karolyi created can potentially provide practitioners with another perspective when gauging the risk and returns in emerging market investments. It can particularly come in handy for emerging market exchange-traded fund (ETF) investors.

And the final answer to the ultimate question after looking at all six dimensions? Malaysia, South Korea, and Taiwan all came in fairly close to the developed market median in 2012 when the research was completed.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, senior director of industry research, CFA Institute, conducts original research with a focus on the investment industry trends and investment expertise. His current research interests include multi-asset strategies and FinTech (including AI, big data, and blockchain). He has led the development of such popular publications as FinTech 2017: China, Asia and Beyond, FinTech 2018: The Asia Pacific Edition, and Multi-Asset Strategies: The Future of Investment Management and is a frequent speaker at industry conferences on these topics. During his time in Boston pursuing graduate studies at Harvard and as a visiting scholar at MIT, he also co-authored a research paper with Nobel laureate Franco Modigliani that was published in the Journal of Economic Literature by American Economic Association. Larry has more than 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio manager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar/Ibbotson Associates, managing multi-asset investment programs for a global financial institution clientele. Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, South China Morning Post and the Wall Street Journal.

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