First, a small–but important–distinction. There are emerging markets located in wealthy nations. They focus almost exclusively on trading of local securities in countries where not many companies are listed and where locals have little interest. Germany used to be one such backwater–and still is, to some extent. Eastern European countries, members of the EU but with rudimentary securities markets, are another.
Then there are emerging countries, and their stock markets. This latter group is what I’m writing about today.
emerging countries’ markets
The securities markets in emerging countries have two important characteristics that I think most investors are unaware of:
1. There’s very little local demand for stocks or bonds. There are usually no institutional investors, because there are no pension funds. The average citizen works a 60-hour week to make, say, US$125. He has no money to put at risk by buying bonds or stocks. He may not trust his local financial institutions. Instead, he may buy gold and bury it in the back yard.
This means that the local markets rise and fall on demand from foreigners. When times are good, foreigners pile in and financial instruments soar. The longer the boom, the deeper into unknown waters (smaller markets, micro-cap stocks) they wade.
Eventually, the tide turns. The first to leave quickly exhaust local demand. The rest can find no one to sell to. Around 1990, for example, developed country investors “discovered” Indonesia toward the end of a long bull run in emerging markets. After the party wound down, it was at least two years before investors with large holdings in Indonesian stocks could even begin to pare them.
2. Local rules can change quickly. Changes can apply either to everyone or just to foreign investors. Capital controls can be imposed that would allow foreigners to sell securities but prevent them from exchanging the local currency they get for anything else, or would forbid them from removing sale proceeds from the country.
Or the government might simply tell foreigners they couldn’t sell …or could unofficially tell local brokers they could not accept a sell order from a foreigner or process a completed transaction.
active managers vs. index funds/ETFs
Veteran investors in emerging markets generally understand that the battle of wits between buyer and seller can sometimes turn into a game of Whack-a-Mole, with them in the role of the mole. They cope either by staying completely away from the riskiest markets or holding only the safest names in small amounts. They meet redemptions by selling some of their holdings in larger, more stable markets if they’re caught in a no-liquidity market.
This is a plus and a minus. On the one hand, fund investors can get their money back. On the other, by rerouting selling from risky to more stable markets, meeting redemptions ends up creating a minor kind of contagion.
Index entities, on the other hand, have little discretion. They don’t have active managers to do selective selling. They don’t want active managers, either. What if the manager sells the wrong stuff and the fund/ETF underperforms, as a result?
ETF selling, which I’ve read has been quite heavy recently, exerts downward pressure on everything in the index–good or bad, sound country or not. This ends up being another, stronger kind of contagion.
The question I don’t know the answer to is what an emerging markets index fund/ETF does with illiquid securities that its mandate (to mirror a specific index) forces it to sell but for which it can find no buyers. My guess is that the firm that runs the index entity purchases the securities in question, after having a third party determine fair value. I don’t know, though.
Anyway, problems in a few emerging markets can quickly spread to the whole asset class.
what to do
At some point, I think the right thing to do will be to look for an experienced emerging markets manager with a good track record, who works in a strong no-load organization. Let him/her sort through the rubble for us. I don’t yet feel a strong urge to do so, however.