Why Emerging Markets Are the Best Place For Protecting Your Retirement Funds
There’s no doubt what the received wisdom is these days. All year the financial press has been echoing the theme that emerging markets are toast. The Fed, we’re told, will shortly be initiating a period of monetary tightening and rising rates. This, we are told, will suction vast quantities of capital out of the global economic periphery towards the havens of the developed world. The dollar will soar in value and emerging market currencies will plummet. Tough economic times will drive global investors towards ‘safety’.
Dr. Jerome Booth disagrees. He recently retired as Director of Research for Ashmore Investment Management where he helped oversee 60 billion dollars in emerging markets assets. Booth’s new book, Emerging Markets in an Upside Down World, makes a detailed case for the emerging world as a long term investment prospect. But beyond making the case for a specific asset class, Booth’s book dismantles the shared but unexamined presuppositions which cause portfolio managers to deploy disproportionate shares of their clients’ capital away from the rapidly growing parts of the world and towards the relatively stagnant, already developed world. In particular, Booth points to modern academic portfolio theory as unfit for the purposes of managing money, too dependent on the idea of volatility as the one and only risk factor, and far too sanguine about excessive debt and inadequate growth in the developed world. Average private and public debt in the developed world average roughly 200% of GDP, while averaging only about 20% in the developing world. This alone should be a concern to global investors, not only in their roles as investors, but as citizens.
Dr. Booth and I sat down across a Skype line to discuss his book. You can read a partial transcript of that conversation below. Some changes have been made for purposes of clarification:
Jerry: “Let me just open up my copy of Emerging Markets in an Upside Down World, which is thoroughly marked up, so I’m only going to ask about the parts where I have more than one star, or a ‘yes’ with an exclamation point. But let me just start out with the beginning of the book: “The world is upside down; the emerging market countries are more important than many investors realise. They have been catching up with the West over the past few decades. Greater market freedom has spread since the end of the Cold War.” Could you elaborate on that please?”
Jerome: “I think the reality of the shape of the planet is a little different to peoples’ perception of it, and a lot of the book is really about, on the one hand, the failure of finance theory or, rather, the inappropriate application of some ideas beyond, if you like, the remit of assumptions behind the theories. And a lot of it’s about prejudice in a way; it’s about how the models that we have about the world are not only wrong, but actually they can change very suddenly, and I think some of the most interesting dynamics in markets are where you have sudden changes of perceptions, and that’s dangerous. So it’s better if we can have a better idea of the world today and adjust to that gradually, than have massive crises when we suddenly realize that, actually, the world is very different and we do have massive problems. It’s also–there’s a big emphasis on the nature of risk. Risk is a four-letter word; it means a lot of different things to different people, and I think we tend to fall into some sort of easy assumptions — most notably that volatility is everywhere and always a good proxy for risk, and it isn’t. It sometimes is, but it’s a very different concept from uncertainty. We need to avoid the idea that if you can’t measure it, it doesn’t exist. And we need to understand that risk is much more complex a concept than volatility, and risk is different for different people; people have different amounts of information, different liabilities, different reaction speeds. So all of these things — some of the interesting things I think that haven’t been said elsewhere — include things about the structure of an investor base being extremely important to how the dynamics (liquidity in particular) can change, often suddenly. What I’m trying to do is, if you like, weave a whole series of threads in the book. It was pointed out to me by more than one person that perhaps it’s more than one book, but I stubbornly persisted in trying to get these various different themes into one book, because I wanted people to see the whole picture. I think particularly when it comes to prejudices, it’s very easy to come up with an excuse [like], “Why, yes, that’s all very true, but…” and I wanted to cover all the ‘buts’. I think there is this view, which is very comforting, that emerging markets are a small part of the world – they’re peripheral – “Yes, of course, they’re growing fast and yes, of course, that’s where the future is and lots of sense is and yes, of course, we should take them into account, but (‘but but but’) China has a problem,” or, “Isn’t there corruption?” or, “Aren’t there political risks?” or, “Haven’t we got bigger problems at home; aren’t our liabilities at home?” And a lot of what I’m trying to say here is that to ignore emerging markets or to belittle emerging markets’ role in an investment portfolio–or from policy point of view, as well–in the way that I think is currently so common is actually to increase one’s risk. It actually is risky not to have a bigger appreciation for emerging markets. And this is trying to think about the future; I’m trying to bring into the argument some of the things which the easy, very automated processes of finance theory have taken out. I’m trying to reintroduce macroeconomics in particular, but also politics and some of the other disciplines back into our thinking in the asset allocation process, not just as a sort of add-on at the end of the day, or something that one delegates to one’s asset manager but fundamentally, at the beginning process of how we think about asset allocation and how we want to achieve our investment goals. Rambling a bit, but hope that answered the question.”
Jerry: “Well, you did answer the question and several, in addition, that I was going to ask. Let’s dig in a little bit more on this idea of financial theory, because I’m sensing a little bit of a pulling of punches in your last answer, but I might be wrongly sensing that.”
Jerome: “Well, let me say that finance theory is not fit for purpose, and that its widespread inappropriate use has caused a distortion in the allocation of assets on a global scale which has adversely affected hundreds of millions of people.”
Jerry: “Well, that’s not pulling punches. But let me ask — when you say financial theory, I assume you’re talking about modern portfolio theory and everything. There’s a sort of raft of ideas all related to one another, they started with the famous Markowitz paper (that’s sort of the beginning, that’s the genesis or the fall, depending on what your view is towards the creation or the fall, of financial theory) where Markowitz is sitting there in the library, reading John Burr Williams which has been assigned to him, I think, by Schumpeter, and John Burr Williams (who is kind of a precursor to capital asset pricing) keeps using this word ‘risk’ and Markowitz stops and says, “He keeps using this word ‘risk’ but he never defines it. I’ll have to define it. I think that risk is, oh, I don’t know – ‘variance’ or ‘volatility’.” And at that moment modern portfolio theory basically is born. But he never gives a reason for that, he never proves that volatility (he called it ‘variance’ but eventually it becomes ‘volatility’) is, in fact, risk or a good proxy for risk, and then six or seven Nobel Prizes later, modern portfolio theory is thoroughly ingrained in every business school, at least in the English-speaking world, and in the CFA exam and everything else, but as a theory that’s never really-to my knowledge-been demonstrated to accurately describe reality. So, I guess my question for you is [this]: Is modern portfolio theory flawed, or is modern portfolio theory perfectly alright, [but] just being used incorrectly? That when I refer to a pulling of punches, it’s that. Is there a problem with MPT inherent to it or is it just that no one knows how to use it properly?”
Jerome: “Let me be a little clearer: I think finance theory is a very new discipline, and it has therefore been making great strides, and I’m worried first of all that the, if you like, novelty of it doesn’t yet make it massively useful, and the use of the theory certainly has overstepped, I think, appropriateness. I mean, I think it’s being used in ways where it shouldn’t be used, and insofar as this is a major problem it isn’t because the academic work is somehow flawed fundamentally. There are problems with that… There are two categories of problems; one is that, yes, there are some flaws. Friedman himself basically said if a theory has neither realistic assumptions nor testable results, then it’s worthless, and I think a lot of finance theory does fall into that category. There’s been far too much maths in economics more generally and people lose sight of the end goal of having something useful to say, so there is that problem.”
Jerry: “Alright, let me do an Anglo-to-U.S. translation: ‘maths’ means ‘math’ and ‘sport’ means ‘sports’.”
Jerome: “Yes, that’s right. That’s certainly a category of problem but I’m not saying that all finance theory’s like that. I also want to recognize [that] there’s been a lot of great progress, and I think a lot of the problem is the inappropriate use of theory and I think that’s the bigger part of the problem…”
Jerry: “You know, there’s an idea [from] Francis Bacon, founder of modern scientific theory – “The Idols of the Den” [The Idols of the Theatre]. The idols of the den are the ideas that everybody you know believes, therefore you never realize you need to question them.”
Jerome: “Similar to Keynes’ famous quote that we’re all hostage to the ideas of dead economists.”
Jerry: “That’s right, and a lot of us are hostage to his ideas. It’s an interesting prophetic statement by Keynes. So, this sort of standard academic financial theory becomes scary to diverge from for anybody in the industry. I’ve noticed that people in the industry get much more nervous about being out of step with their peers than they get about the risk of losing assets for their clients. They’re much more afraid that they’re going to break off from the pack and be found wrong, often, in my experience, than they are afraid that they will follow the pack and lose money for their investors, for the clients.”
Jerome: “I think that’s absolutely true, and we see forms of doublethink occur all the time. I mean, talking to central bank governors or reserve managers, more specifically, who will go and buy tons of U.S. treasuries or boring assets that they wouldn’t dream of buying themselves on account of the risk and the likelihood of exchange rate movements or changes in the yield curve, concentration risk, and all the rest of it.”
Jerry: “And nobody gets fired for hiring IBM. Isn’t that the old saying? No one ever got fired for hiring IBM.”
Jerome: “Yes, and that’s a principle agent problem. It’s the incentive to be in the herd. I remember I was talking to a Californian pension fund manager once, and we had been talking about the need for GDP weighting, and the logic there is that what most investors want is future income. The best measure of future income is past income, the best measure of that globally is GDP. The manager-the head of staff, the chief investment officer of a pension fund-said, “I completely agree with you, Jerome, about the need to have a much higher weighting in emerging markets,” (a result of this GDP argument), “I also completely agree with you that we all have these terrible agency problems and we all have this herd mentality. But I still have to be in the herd, Jerome. What I can do, though, is I can be at the edge of the herd. So if, you know, my peers have 10%, as some of them do, in emerging debt then I can go to 10%, but I can’t go to 15%. I have to wait for that to be completely normal.””
Jerry: “You have to wait for the herd to move, but by the time the herd moves, a lot of the best grass has been eaten.”
Jerome: “Not only that, but collectively I think we face the problem that the herd is now moving slower than global reality.”
Jerry: “Until it stampedes.”
Article originally published on RealClearMarkets.
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