The crisis currently roiling the developing world has revived a debate in some circles about the very validity of the “emerging markets” concept. Used since the early 1980s as a convenient moniker grouping countries that were thought to be less developed — financially or infrastructure-wise or due to the size or liquidity of their financial markets — the widely varying performances of different countries during the turmoil has served to underscore the differences rather than similarities between them. An analyst who traveled recently between several Latin American countries summed it up by writing that he had passed through three international airports during his trip but had not had a stamp in his passport that said “emerging market”.
Like this analyst, many reckon the day has come when fund managers, index providers and investors must stop and consider if it makes sense to bucket wildly disparate countries together. After all what does Venezuela, with its anti-market policies and 50 percent annual inflation, have in common with Chile, a free market economy with a high degree of transparency and investor-friendliness?
Deutsche Bank analyst John-Paul Smith is one of many questioning current index-based investing models which he says essentially provide a free ride to the Russias and Venezuelas of this world, who may be undeserving of investor dollars. Simply by virtue of inclusion in the emerging index, a country becomes a “default beneficiary” of passive investment flows — from funds that hug or track the benchmark — Smith says. In a note he calls for the abandonment of current index criteria such as market access, liquidity or per capita income in favour of a “substantive governance-based view of risk”
In other words:
The classification of what constitutes a mainstream emerging market should, in our view, be reworked to take account of the relationship between the state and minority investors in listed companies, with a particular emphasis on the level of transparency and the institutional backdrop.
Smith also argues in favour of changing investment rules to make funds less benchmark-constrained, giving them access to a broader investible universe. Managers should also be permitted to hold much higher levels of cash, he recommends, rather than having to hold “least bad” stocks, as is currently the case.