Archive for Emerging Markets

Sovereign Wealth Funds; A Potential Force from Within For Emerging Nations

Posted in Emerging Markets, Financial Markets, Sovereign Wealth Funds with tags , , , , , , , , , , , , , , , , , , , on May 23, 2009 by evd101

By Erik L. van Dijk



A lot has been written in recent years about the so-called Sovereign Wealth Funds(SWF’s). Wealth Funds are large pools of money, created by governments or governmental institutions. The Western world is not totally unfamiliar with huge government pools of investments, but normally we associate them with state pension funds. Some wealth funds, like the Norwegian one for instance, do indeed have this form. In other cases the wealth funds resemble long-term investments funds or stabilization funds, used to ensure that one or a few dominant sources of income with volatile prices (e.g. oil and gas) don’t disrupt a country’s national income trends through spectacular ups and downs in GDP caused by large price and / or demand-supply fluctuations.

As so often with new trends, market analysts, journalists and governments have expressed fear that the SWF’s might become too big a force in the market. Are these concentrated portfolios really invested with pure investment motives in mind? Or are strategical and political factors incorporated in the investment philosophy as well? Quite a few pundits have expressed doubts concerning the pure investment activities and skills of SWF’s. They rather stressed the political danger of these institutions.

As if Western goverments do always apply pure investment motives when spending their budgets! SWF’s are extremely large and do invest a substantial percentage of their wealth abroad. Now, if they would have been political entities, investing abroad and going against the rules and regulations of the recipient country is risky. Recipient countries could take nasty countermeasures ranging all the way from court cases and penalties to nationalizations.

SWF’s; a powerful but relatively new phenomenon

In this blog entry we study the pool of existing wealth funds a bit more deeply using the database of the SWF Institute. The database contains some 55 wealth funds from developed and developing countries. The SWF’s from developing economies form the majority (41 out of 55, or 74.5%). This might seem strange, but it is not. When income distributions are relatively unequal, it is not uncommon that governments try to get a piece of the action. And especially the goverments of resource-rich nations have a nice opportunity to do so. However, the structuring of those investment pools into wealth funds implies a professionalization that is rather new. The average year of establishment of the 55 funds in our empirical study was 1995, albeit it that one of the most famous wealth funds – the Kuwait Investment Authority  with USD 202.8 billion under management- was founded in 1953.  And the Foreign Holdings portfolio of the Saudi Arabian Monetary Authority (SAMA)– with USD 431 billion assets under management – was created in 1952. But some of the real big ones aren’t old at all. Here are some of the most remarkable entries since 2005: China Investment Corporation (2007;AUM USD 207 billion), Libyan Investment Authority (2006;AUM USD 65 billion), the Russian National Welfare Fund  aka National Wealth Fund (2008;AUM USD 83.6 billion), and the Investment Corporation of Dubai (2006;AUM USD 82 billion)

The SWFs are an enormous force now and we should not underestimate their impact and influence. Total assets under management for the 55 SWFs in the database continue to show an upward long-term trend and the current level of AUM is USD 3,585 billion. When looking at the amounts needed to repair our financial industry and cope with the credit crisis, this implies that Wealth Funds might be able to play an important role in any recovery plan. It is therefore quite remarkable that Western leaders so far seemed to focus on a strategy based on ‘look to each other, and solve together’. Didn’t we basically make the SWFs in the Middle East and Asia richer by buying their oil and  gas or cheap products, thereby creating a moneyflow from West to East? Only Gordon Brown and Barack Obama seemed to be willing to concentrate efforts on the Middle East (Saudi Arabia and Gulf States). The opening up to Iran in recent periods can also be seen as an important step. Iran is probably one of the most secretive nations as far as its wealth fund(s) are concerned. The Oil Stabilization fund is well-known, but too small to be the whole story. Currently the US and its Western allies on the one hand, and Iran on the other are going through a serious political chess game with probably just one goal. To find some kind of common ground to get Iran back in the league of ”’acceptable” nations. The Roxana Saberi case illustrates how tensions are orchestrated and reduced in a purely political rhythm. In normal situations it would be unheard to see Ahmedinejad suggest things like this to judges within the Iranian judiciary system.

In terms of goals, we see that the bulk of SWFs start of as stabilization fund, and gradually but slowly moved to a role as state investment funds with long-term investment horizon. A next step is the transition into full-fledge pension system, at least with a substantial part of the assets involved. A growing number of nations understand that the creation of a pension system provides countries with a tremendous source of savings and investment potential that can help stabilize the political situation in a country and fight extremist tendencies while at the same time helping to stabilize the economy.

SWF’s; The New Capitalism?

When comparing the SWFs with other large institutional investors, there are some structural differences. One of the most important ones according to us, and that holds especially for the SWFs that are based on energy- and commodity-related wealth, is their ability to concentrate on (ultra) long-term growth. This will enable them to capture higher returns by locking in the higher risk premiums on riskier investments while working with an asset mix that is more tilted towards riskier asset classes. Obviously, with this type of SWFs often being from countries that did not establish themselves as major financial powerhouses yet, we need to place a caveat. The level of knowledge within the SWFs might be a constraint. In recent years we did indeed see some indications of suboptimal asset management in the SWFs. Some tended to link this to strategic motives, but a closer look at the asset allocation, holdings acquired et cetera indicated that this was not the whole story. Lousy ‘picking’ at the bottom-up level has played a far more important role. The sad investment story of Chinese insurer Ping An that bought a stake in Dutch-Belgian financial conglomerate Fortis at about the worst moment possible is indicative. This is not to say that there aren’t any ultra-professional, well-managed SWFs. But the difference in investment expertise is still striking and far bigger than it is within the institutional investor community in Europe or the US.

Now, with their long-term focus, enormous wealth, and huge size compared to the local economy (which automatically implies that the focus has to be to quite a large extent ‘international’) and top-down, hierarchical decision structure SWFs are definitely not pension plans like the ones we know in Western Europe or the US. Their relative lack of transparency concerning decision taking, performance analysis, compliance et cetera further strengthens the case that this is really a new category of investors entering the stage.

Sure, when looking at total assets under management Western institutional investors are – as a group – still far more important. However, also more fragmented with smaller average sizes and with a much larger focus on low risk, fixed income assets. The impact of SWFs on global stock markets will therefore most likely increase tremendously in the years that lie ahead of us. First of all, because the economic growth rates in the nation mix of SWFs are higher than those in nonSWF-dominated economies. Second, most of the traditional Western institutional investors don’t really grow that fast anymore with the inflow of pension premiums more or less offset by payments to pensioners, with demographic trends making it almost impossible that this will really change.

This implies that we need to take a closer look to what could happen in the future when taking these trends into account.

China will win, but energy-related SWF’s should not be underestimated in the next 10-15 years

Although the Asian SWF’s are gaining in importance, led by the Chinese Wealth Funds that benefit from the country’s growth record, the oil-related wealth funds will be a dominant force to reckon with for quite some time to come.

The energy-related wealth funds represent a bit more than half of the group of 55 when we look at the number of funds (31), and in terms of assets under management their total of USD 2259 billion represents 63 percent of total AUMs of the wealth funds.

So, unless the growth rates in China and some other Asian nations reach record highs, with oil prices remaining sluggish, the Middle Eastern SWFs – actually the group that most people fear because of their lack of transparency – will remain a very important category to take into account. We at Lodewijk Meijer believe that it is not just for this reason important to ensure a dialogue with this group of wealth funds. Also when looking at the political situation in the Middle East and the problems with global terrorism, an open and fair communication, trade and investment relationship with the countries in the Middle East will certainly be beneficial in these areas as well. The West should recognize that quite a bit of the tensions are directly related to flawed drawing of country borders in the Middle East by Western occupiers in the past in combination with giving Western oil companies too large a stake vis-a-vis the revenues left for the energy-rich countries itself. Add to that the fact that quite a few nations were or are led by leaders that do not have the support of the population to the same extent as they have Western support and an important part of  the terrorist story is explained.

Development and growth in general have always worked against terrorism. Terrorists thrive in climates with inequality, lack of chances, and poverty. The SWFs and their growth stories will definitely make it less likely that MENA countries themselves – as a group – will witness increased terrorist activity. Skepticists will add that they will have more funds available then to support terrorist activities elsewhere, but we tend to believe that this risk is far more greater when not allowing these nations a dialogue and place within the family world nations, while at the same time helping their SWFs to further professionalize and internationalize their portfolios. This is a win-win situation for all.

SWF’s and the local economy; catalysts for growth….

but local growth can only thrive when economies develop further and governance improves:

The Trinidad Case

SWFs are huge. Often too huge compared to the size of their local economy. They do therefore have to diversify internationally. This implies that their wealth that was often created through Western imports of oil, gas and relatively cheap products will in the end – to quite some extent – flow back to us and other nations via financial market transactions.

That is not to say that SWFs cannot play a fantastic role when developing the local economy of countries. Their potential to be a catalyst of growth is huge. A nice example is the situation in Trinidad and Tobago.In an earlier entry to this blogwe told a bit more about the country, one of the least know oil states in the world. Most people outside the region still believe that the whole Caribbean is about tourism and tropical products, but Trinidad and Tobago is definitely an important exception with attractive growth potential that makes it an interesting Frontier Market.

The country’s Heritage Fund has assets under management of USD 2.9 billion or about 12 percent of GDP. And that percentage will be growing assuming that oil and gas prices will at least stabilize. Trinidad wants to establish itself as a regional financial center and we believe that this strategy could work when undergoing a structured transformation of the economy and upgrading of the financial market system. When taking into account that Cuba will probably be an interesting new entry to CARICOM any time soon (we at Lodewijk Meijer think that it could take approximately 3-5 years for this to happen), that regional financial role could really be of tremendous importance. The ongoing growth in the trust/offshore business in the CARICOM region could also further improve things, with Port-of-Spain then becoming a logical on-shore financial center for the off-shore islands of the region.

When talking to local leaders and international investors, we believe that the opportunities are there.

However, one thing that worries us – and an area where change is needed – is the relatively low country score (3.6 on a scale of 1 to 10 with 10 being the highest) on the Transparency International Corruption Index (CPI). Activities undertaken by institutions like the Caribbean Procurement Institute, Trinidad and Tobago’s chapter of Transparency International and by politicians with large popular support and a willingness to change things could all help. Currently, developments in the ongoing proceedings of the Uff Commission of Enquiry into the Construction Sector of Trinidad and Tobago seem to indicate that – as so often in many nations, even developed ones, – construction and real estate are the areas where lacking corporate governance and fraud have led to a situation in which public funds were misused for personal gain by corrupt politicians/bureaucrats and/or entrepreneurs (e.g. within the construction industry)  and/or lost through incompetency, with a political chess game being played in the background. When analyzing the corruption proceedings, we believe that the nepotists seem to have decided to make former minister of Housing Dr Keith Rowley (one of the most popular politicians in the country, with a tremendous track record as far as new housing activity is concerned while he was in charge of that ministry, and one of the architects of the Vision 2020 report in which the transition into a more diversified economy was first introduced) their scapegoat over a negligble malperforming housing project after he left office. And not just that, too much decision power was and still is not in the hands of ministers in the first place, but is concentrated within UDECOTT;  the Urban Development Corporation of Trinidad that seems to act like a kind of state within the state.

 The Commission will present its final report in September 2009 and we are optimistic that it will unravel a smelly truth about what is a standard nepotism case so often seen in developing economies. Local newspapers help set the stage for a climate in which nepotists are forced into defensive positions. This is a tendency quite often seen in developing nations. When the country develops and corruption fighting grows into a serious countervailing power, the growing independence of the media is not just an important sign of this, but a tremendous catalyst as well. The country’s growth story and transition into a more diversified economy with expanded financial sector will further improve things. Smaller local nepotists will lose out when ‘big finance’ discovers the region. Huge financial institutions will – through the investment opportunities they provide andthrough their larger focus on procurement and ESG strategies (they have too much at stake to be caught in local scandals!)- basically provide the final blow to the nepotists even when the Uff Commission verdict doesn’t already do so in a legal setting.

Along the way the role of the Heritage Fundwill become more important; a) as the largest local investor; and b) as entity attracting the professional skillset of international investors, litigation lawyers, investment bankers, asset managers, investment analysts et cetera. Either directly (to work for the Fund) or indirectly (through provision of services by parties wanting to establish a position for themselves in the country).

This Trinidad example is illustrative for developments in many Emerging economies. And the trends we see developing here have so far shown that in successful growth stories external money and expertise went hand-in-hand with a local willingness to fight corruption from within. And from an investment point of view: it is actually this group of Emerging and Frontier markets where both components are visible, that actually have showed the most attractive return-risk profile.

SWF’s and the international economy; a growing role to play

With total assets under management of USD 3585 billion, it is clear that SWFs can be an important force when leading us out of the current credit crisis. The combined assets of the big Western institutional investors are still far larger, but SWFs are quickly catching up.

We foresee that their role and positive contribution will substantially increase during the next 6 to 12 months, with the beginning of a positive change already under way. Part of the 30+ percent stock market return generated during the first 5 months of 2009 was directly related to SWFs stepping in (finally!) looking for bargains.


SWFs are a relatively new phenomenon. Their large pools of funds are of tremendous importance to the domestic economy and are a great support for the world economic situation as well, because most of the SWFs are too big to concentrate on a home-alone policy. They have to diversify internationally to a larger extent than most other institutional investors a) because the local economy is not big enough; and b) because it is often not diversified enough.

Western nations have often complained that investment behavior by SWFs was to a large extent guided by strategic instead of economic principles. So far evidence in this direction has not been convincing at all. Sure sometimes strategic motives might have player a role, but wasn’t that the same for Western investments in our past?

The attraction that economic development and wealth funds have to international financial instutions that might want to provide services to them will trigger a climate of financial sector dynamics and growth. What could hurt the positive potential effect of this is often a local climate in which nepotism and corruption thrive. Once that threat is neutralized, the upside potential will be tremendous.


The Value of Virtue

Posted in Behavioral Finance, Emerging Markets, Financial Markets, Risk Management with tags , , , , , , , , , , , , on April 10, 2009 by evd101

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

  1. A higher level of corruption translates into lower domestic investments and economic growth
  2. Higher levels of corruption hinder Foreign Direct Investments
  3. Higher corruption leads to lower tax revenues
  4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
  5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
  6. Higher corruption leads to higher student dropout levels in universities and high schools
  7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

  1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
  2. There must be some kind of economic merit associated with that power
  3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

  • Protestantism;
  • Former British Colonies;
  • Higher GDP;
  • Common Law versus Civil Law-based legal systems;
  • Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
  • Longer exposure to democracy;
  • Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

  • Relative salaries in the public sector;
  • Degree of political stability in a country;
  • Endowment with natural resources;
  • Degree of state intervention in the economy;
  • Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

  • Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
  • About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
  • Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
  • Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
  • And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

  • Return on Equity (for the P/B analysis)
  • Return on Assets (for the Tobin’s Q analysis)
  • Profit Margin (net)
  • Research and Development Expense / Sales
  • Dividend Payout
  • Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
  • Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
  • Earnings growth (5 years)
  • Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

  • Country level average Return on Equity (for the P/B regression)
  • Country level average Return on Assets (for the Tobin’s Q regression)
  • Inflation
  • GDP growth
  • And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue

Smaller Frontier Markets: Hidden Opportunity or Totally Uninteresting? The Trinidad Case

Posted in Asset Allocation, Emerging Markets, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on April 2, 2009 by evd101

By Erik L. van Dijk


In the first entry to this blog we presented one of Goldman Sachs’s Next-11 countries, Iran, as an interesting ‘neglected country’ for speculative investors. On the one hand, we saw an economy built on huge oil and gas reserves (which provide a kind of collateral or put option to your investment strategy in the country) and on the other we saw growing signs of structural talks between the US and other Western nations with Iran in the political arena. The fact that Frontier economies like Iran and others (Kazakhstan, Vietnam, Saudi Arabia are also well-known representatives in this category) have a relatively low correlation with the MSCI World index and even with the MSCI Emerging Markets index are of interest to large investors that want to diversify their portfolio. But we also know that smaller economies are more sensitive to the potential risk of growing protectionism in a world that is struggling with the credit crisis. We did therefore decide that it might be good to look at a smaller Frontier Market as well, to see how things are going there.

Our Emerging Markets unit decided on Trinidad and Tobago. On the one hand (see also below) the country is not a tourism-dominated, one-dimensional banana republic, but one of the richest Caribbean nations with an economy built on strong oil and gas reserves. On the other, we see a relatively stable political situation, a leading role within the CARICOM (the regional cooperative entity between some 15 Caribbean states) and an English-speaking population. When we add to that a legal system that has tight links with British rules, it makes for a Frontier market that is definitely ‘unknown’ and ‘neglected’, but also not ”scary” like so many other exotic nations in this group.

In our databases we have daily stock market information about Trinidad and Tobago (TT) starting from May 2005. Almost 4 years of data split up in a good period for world exchanges (2005-2006-beginning 2007) and a disastrous one (second half 2007 and especially 2008-09). A relatively short period, but definitely an interesting one when trying to get a feel for Frontier Market investing, its opportunities and its dangers.

When we look at the index information (in USD) over this period, it is not surprising that the net result for the period is not a good one for global equities. The effect of the credit crisis is clearly visible in the numbers. The MSCI World index generated an annualized return of minus 7.82% for the period. When we compare that with the plus 8-10% positive return normally expected for global equities, it is clear that we are dealing with a dramatic  outlier here. Everybody states that when the rich, developed world is sneezing, smaller Emerging nations are catching a cold. Now, when we look at the annualized return over the period for the MSCI Emerging Markets index we derive a figure of 2.58% positive (!). So notwithstanding the fact that Emerging Markets did indeed drop a bit more than developed ones in the  2008-09 (until March 27)  period (-58.87% compared to -51.81%), their positive net result indicates that the value gain in the May 2005 – Dec 2007 period compensated for that. It was the period when the BRIC nations gave the leading Emerging Markets economies their new catalyst role. Obviously, some (e.g. Russia) suffered more than others, but all in all the correlation with developed nations was quite high, and return differentials not that big and there wasn’t really a big cold. When we look at the MSCI Frontier Markets index we see where the old adage about sneezing and catching a cold comes from: the smaller developing economies in this index were the ones struggling. The MSCI Frontier Markets index lost on average minus 14.65% on an annualized basis during the period May 2005 – End of March 2009! Trinidad and Tobago (TT in the remainder of the entry) was actually a big outperformer with an annualized return of minus 7.65% for their equally-weighted First tier stock market index and minus 8.03% for the marketvalue-weighted one. Lodewijk Meijer decided to look at both equal-weighting and value-weighting due to the fact that the TT stock market index is to quite some extent bank/other financials-dominated. But analysis made clear that although the banks and other financials did indeed suffer quite a bit, their story wasn’t as bad as that of many of their huge US and European colleagues that ended up at the brink of bankruptcy.

So, in and of itself the performance of the TT exchange wasn’t good. Relatively speaking the7 percent outperformance compared to the Frontier index was interesting, and so was the countries solid oil- and gas-based economic basis. If we add to that government initiatives to play a larger role within CARICOM on the one hand and ideas about setting up a regional International Financial Centre (IFC) on the other, we found it interesting enough to present TT as our representative small frontier market. And besides: don’t forget that the main stock market wisdom says that you have to buy low and sell high. So one could also present the bad performance of the Frontier Markets as an opportunity to step in if you believe with us that mean-reversion of global markets will indeed set in in 2009 (6-12 months before seeing the first signs of the economic recovery that normally follows the stock markets).

But it is not just that: we also looked at volatility (measured as the standard deviation of return) as absolute risk indicator and beta (indicator of systematic risk, measured as percentage average return when the world index changes 1%). High volatilities and high betas are then indicative of risky markets and low volatilities and betas of less risky markets. Since we compare things with the MSCI World index when calculating betas, the MSCI World has – by definition – a beta of 1. The MSCI World had a volatility of 20.53% annualized for the whole period and 32.76% for the 2008-09 period. That is a huge number. The 32.76% translates into an almost 35 percent likelihood that the actual realized return will fall outside an interval ranging from -22.76% to +42.76% when you expect a 10% return on stocks. I am sure that none of us will mind a more than +42.76% return with a probability of almost 17.5%, but there is a similar chance of ending up with another terrible year of more than a 22.76% loss! This is indicative of the turbulence in the global economy, with especially larger countries now being very nervous due to enormous tension of their financial systems, the unwinding of struggling hedge funds et cetera. In normal situations the Emerging Markets would have both higher betas and higher volatilities. But the beta for the period was actually 0.972, i.e. the Emerging Markets reacted more or less the same to bad or good news as the developed ones. Their normal excess country and firm risk  (in general) was compensated by the fact that our financial system in the West was under enormous pressure. The volatility was still higher in Emerging Markets, but actually not that much: 26.60% in EMs for the overall 2005(May)-2009(March) period (versus 20.53% for the MSCI World). And in the 2008-09(March) period the EMs went up to a volatility of 39.27% versus 32.76% for the MSCI World. It is indicative of a changing world in which the New World Order (with bigger role for China, India, Brazil and Russia) is gradually but slowly happening. And that will make Frontier investing more interesting as well. The BRIC nations are known to be more active with investments in the Frontier markets, see for instance how the Chinese and some Sovereign Wealth Funds are increasing their influence in Africa.

Frontier Markets are amazing when looking at their risk profile. They are the least risky ones when taking a first look at volatility and beta. The beta was relatively stable for the period (0.178 for the overall period and 0.188 for 2008-09). Far lower than the beta for Emerging Markets or the MSCI World. And the volatility was only 17.74% and 24.15% respectively!

How is that possible? Where is the investment risk when opting for a Frontier Markets strategy? Are they really less risky? Yes and no. They are less risky in that these numbers are correct. They do move less when analyzing day-to-day or week-to-week price movements. But what is going on here is to quite some extent related to illiquidity and thin trading. You can compare investing in Frontier Market public equities quite a bit with private equity in Western nations. Share trading is thin and that suggests a peacefulness that is only there as long as new news items aren’t too big or investor-induced portfolio trades (for non-firm or non-country related factors) not too dramatic.

Lesson 1 for the investors:

Never forget about illiquidity of Frontier Markets

When you go there, be sure to have a longer-term strategy based on fundamental (i.e. not speculative, trading-oriented) factors, especially when you are big.

When you are too big: forget about it.

And that brings us automatically to lesson 1 for the frontier country.

Lesson 1 for the country:

Make sure you create trust in your exchange.

And also ensure sufficient liquidity!

 And that is where TT has its main problem. Volatility levels during the period for the average firm in the market were so low that you might almost think that TT stocks were bonds. When looking to daily data the volatility was 4.78% over the period as a whole and 5.47% for the 2008-09 period. Academics have written tons of papers about the adjustments that are necessary to correct for thin trading, with the work of Scholes and Williams in the second half of the 1970s basically being the start. Without going into detail in this direction, we would like to compare the low volatility and systematic risk with what you could see in private equity strategies. In private equity we do not have daily price quotes as a result of which annualized return and risk levels are based on far less data points with a larger interval between them. To some extent the situation here is similar. Abou 3-3.5% is the turnover (as percentage of market capitalization of stocks) at the TT stock exchange. Compare that to the 50-100% rate seen on most Western developed exchanges! It is much closer to the 0 percent liquidity of private equity.

Question then: is the ultra-low liquidity enough reason to forget about a country? The answer is no. Frontier Market investors should know that the characteristics of investments in these markets do have quite some similarity with private equity. In and of itself that is not necessarily bad. Especially now, low correlations and low betas (TT has a beta of about 0 with the MSCI World) are qualities that can be of interest when creating diversfied portfolios. However, the investor should at all times be aware of this aspect of Frontier Market investing. Don’t do it when you don’t have the time to wait and/or the advisor with fundamental knowledge of the markets to support you.

Trinidad: The Country

Columbus arrived in Trinidad in 1498. The Island state has an overall size of just 2000 square miles, neatly situated outside the famous Caribbean hurricane belt. Initially the Spaniards occupied the country, but they never took the colonization very serious. In 1797 the territory became a British colony, a situation that lasted until its independence in 1962. Ever since the linkage with the UK has been prominent, with the British Privy Council for instance being the highest Court of Appeal, with the Caribbean Court of Justice (2005) – an institution of the regional cooperative body CARICOM – now being prepared to replace it. Politically this strong linkage with the UK has ensured relative stability in a democratic system in which not more than 2-3 political parties seemed to play an important role. It was only in 1990 that a Muslim movement led by Yasin Abu Bakr (Lennox Phillips) created some turmoil through a 6 day coup effort. But even in this case, the TT definition of turmoil turned out to be nothing like what we have seen elsewhere in Emerging and Frontier economies. Helped by large oil and gas reserves, the increase in oil prices in the 1970s and again in the period 2003-2007 has led to a tremendous increase in average wealth with now an income per capita in USD of $ 18,600. As is normally the case, political stability and wealth increase were highly correlated.

The small Island state (1.2 million people, of which 96 percent lives at Trinidad and only 4 percent at Tobago) has a remarkably mixed population, with 80% being of Indo-TT or Afro-TT descent. The Indian group is the larger of the two by a small margin. The other 20 percent is made up of Europeans (whites), Chinese, Syrians and Lebanese and mixed people. With political parties to some extent catering to the needs of ethnical and to some extent also religious groups, it is quite remarkable that the political situation is as stable as it is. And there isn’t really any reason to believe that this will not continue.

The only worry seems to be that the population is not growing at all with the relatively small (for Frontier Markets standards) net population growth rate due to births minus deaths being compensated by net emigration to (mainly) the UK, US and Canada. That could create problems for an economy with ambitious growth targets.

Trinidad: The Economy

TT has a GDP of US $ 24.2 billion. The GDP growth rate dropped recently from 8% to 5% and we foresee a further drop to about 3-3.5% due to the strong linkage with oil and gas. But it is still a growth rate and that is something that a lot of countries cannot show anymore in this period of crisis and turmoil that we are in. Governnment debt is low at 28% of GDP. The proven oil reserves are some 728.3 million barrel and gas reserves are at 481.3 billion cu m. Nothing like the huge reserve numbers we showed earlier for Iran, but still in general with a bit fantasy you could say that it is like a smaller version of Iran. Neglected, but with a nice collateral and in this case (to compensate for the smaller collateral) a situation where no one in the world has any problem with this sympathetic Island of steel drums, soca, calypso and limbo (contrary to what people think about the Islamic Republic).

Gas is recently getting more important than oil, with the country now being responsible for some 70% of the US imports of LNG. Oil and gas are responsible for 40% of GDP and 80% of total exports. But only 5 percent of employment is related to these industries and that helps explain the emigration trends.

But the government is trying to create a diversified economy, which looks like anything but a tropical island resort. Sure, Tobago is to a large extent tourism-oriented, but Trinidad has expanded in the following sectors: petrochemicals and plastics, manufacturing (steel, aluminum), cement and food and beverages. And even the old agricultural sector (a very important part of the economy before oil and gas prices started to rise in the 1970s) is not insignificant, with citrus, coffee, cocoa, rice and poultry being important crops.

The country posted a US $ 5.7 billion current account surplus over 2008, which is about 22.5% of GDP with the US being the most important trading partner (57.5% of exports and 20.2% of imports). For more detailed information we refer the reader to the CIA Factbook.

Not surprisingly with the US being so important and with economic results being relatively OK, the country had no difficulty to maintain a more-or-less stable exchange rate vis-a-vis the US Dollar. The TT dollar sells for about 6.2-6.3 to the US dollar ever since 2004.

The ambitious government of Patrick Manning, the prime minister, has indicated that its target is to become a developed nation by 2020. From frontier to developed in 15 years. Not impossible (look at Singapore), but a lot has still to be done. Especially in the financial system, and a government white paper, written in 2004, shows that the government is aware of this. The ambitious goal is to transform TT into an International Financial Centre (IFC) for the region. This regional approach of the government does also show a sense of realism (TT as stand-alone entity is probably too small to achieve very ambitious goals). But creating this IFC is easier said than done, knowing that we come from a low base in the financial sector and that regional cooperation through CARICOM implies that some 15 nations one way or another have to cooperate.

But there are a few factors that might help the government. First, due to the economic development in South America (mainly Brazil of course) and its strategic location between South America and the US, the interest in the region is indeed growing. Not just from regional parties, but also from Europe. The latter is also helped by actions from various European governments against tax havens like Luxemburg, Switzerland, Monaco, Liechtenstein et cetera. The region is already known for having a few alternative tax havens here (Cayman Islands, Virgin Islands, Barbados, Turks and Caicos et cetera) and TT will not copy their effort, but when international money flows will lead to a net inflow into the Caribbean area, the better developed nations will benefit if-and-only-if they do provide the financial infrastructure for the regional money inflow. Something similar happened to Singapore in Asia and Dubai in the Middle East. And that is the two examples that the TT government probably has in mind. What are the odds?

Trinidad: The Exchange

When comparing Dubai with Singapore as the two main examples we would like to use for TT, there are a few differences and they are important. Singapore has been successful because it was capable of not just transitioning the economy (with a huge role as regional transportation hub via the harbour and its prestigious Singapore Airlines), but also as financial center with a well-respected, developed stock exchange.  The creation of strong Sovereign Wealth Funds like GSIC and Temasek played an important role as well.

The Dubai story is younger of course, but we are not convinced yet that this ”walking on two legs” (economy and exchange) is successfully implemented here already. There is still a long way to go.

The same holds for TT. The first tier of the TT stock exchange lists some 30 stocks with a total market capitalization of TT $ 73.5 billion as of March 27, 2009. That translates into some US $ 12 billion, i.e. about 50 percent of GDP. A stock market size of 50 percent of GDP is reasonably OK for Emerging or Frontier Markets standards, but still low compared to levels in developed nations. And the reason is immediately clear when analyzing the group of 30 Tier 1 firms. With oil and gas being the main drivers of the economy, they are more or less absent from the exchange. A lot of economic activity is done by affiliates of foreign oil/gas companies and the main exception is Neal and Massy Holdings (NML). The NML conglomerate (with activities in other industries as well) is in market cap only 6.7% of the exchange, but holds an 18.4% stake of total annualized turnover. What is needed are more listed proxies for these two most important sectors of the economy.

In this respect, TT resembles Iran a bit. The Tehran Stock Exchange is also dominated by firms outside the oil and gas sector (with Iran Telecom since its IPO in 2008 being dominant). But countries that want to grow their economy and financial sector should be aware of the fact that international investors do not really like exchanges that are not a good proxy for the underlying economy.

Lesson 2 for the Country:

Do what is needed to increase the percentage of oil and gas related listings and trading at the Exchange

In terms of market capitalization the following 5 firms are the most important ones:

  1. Republic Bank TT $ 13.8 billion (=18.8%)
  2. First Caribbean International Bank TT $ 13.7 billion (= 18.6%)
  3. ANSA McAl TT $ 7.7 billion (= 10.4%)
  4. Scotiabank Trinidad and Tobago TT $ 4.9 billion (= 6.7%)
  5. Neal and Massy Holdings TT$ 4.9 billion (= 6.7%)

And in terms of stock market turnover, the top-5 is as follows:

  1. Republic Bank TT $ 604.1 million (= 31.2%)
  2. Neal and Massy Holdings TT $ 357.0 million (= 18.4%)
  3. Sagicor Financial Corporation TT $ 197.2 million (= 10.2%)
  4. Guardian Holdings TT $ 175.2 million (= 9.0%)
  5. Trinidad Cement TT $ 78.8 million (= 4.1%)

The much lower numbers of the turnover are illustrative of the illiquidity problem. In line with the government plans to stimulate the financial industry, both the market value and turnover lists show 3 financial firms: Republic Bank, First Caribbean International Bank and Scotiabank TT in the market value list; and Republic Bank, Sagicor and Guardian in the turnover-based list.

When looking at stock market performance over the period 2005(May)-2009(March), the top 5 performers were:

  1. Readymix West Indies (0.51% of the mv weight and 0.75% of the turnover weight) +37.67% annualized
  2. Trinidad Publishing Company (1.24% of mv and 0.28% of turnover) + 19.24% annualized
  3. Williams LJ B (0.05% of mv and 0.03% of turnover) + 11.34% annualized
  4. ANSA Merchant Bank (3.32% of mv and 0.69% of turnover) + 10.19% annualized
  5. Angostura Holdings (1.82% of mv and 0.68% of turnover) +8.60% annualized

In other words: the five best performing stocks were all relatively small (or less tradeable part of a bigger entity). Readymix is a cement producer, Trinidad Publishing Company is itself part of the also listed ANSA McAl conglomerate with the bulk of shares still being owned by the latter. LJ Williams is a trading / manufacturing conglomerate. ANSA Merchant Bank is just like Trinidad Publishing Company also part of ANSA McAl. Angostura is one of the main producers in the beverage sector.

The worst performers were mainly in the financial industry, albeit not necessarily the general banks.

Challenges for the Country

The big challenge for the country, when embarking on this route towards developed status by 2020, is how to attract foreign capital. Foreign – if possible institutional – capital will not only boost the economy, it will also provide it with the necesary seal of approval when moving towards International Financial Centre status within the region. Foreign ‘neglect’ by portfolio investors will automatically be interpreted as a logical confirmation of the ‘neglected country’ status.

But, to attract foreign capital, the stock market infrastructure needs to be improved. The 2008 survey by Transparency International from Berlin (Germany) gave the country a score of 3.6 on a scale from 10 (perfect) to 1 (totally corrupt). With that number the country ranks at place 72 in the world. The score is equal to that of China and Mexico. It is not dramatic, spot 72 in a list with 180 countries, but it is definitely not good enough if your ambition is to become a regional financial center.  

But there are good initiatives on its way or they have already been started. One of them is the creation of a Caribbean Procurement Institute in close cooperation with specialists from abroad. Assuming that TT can be successful in creating an improved regulatory framework, the next step is to ensure that there is enough to invest in for the foreigners.

Something that makes sense also when comparing it with the structure of the underlying economy. Some kind of (semi-)government vehicle could do the trick for the oil and gas sector, i.e. through some energy fund. An IPO of (part of) the telecom provider TSTT would also be an interesting idea, basically copying the example of Iran.

Fears about the outflow of capital are not valid in a country with such a huge current account surplus and a relatively small public debt service. The improvements in regulatory framework and liquidity of the exchange will translate in a reduced corporate cost of capital as well, thereby stimulating the economic growth further.

The expansion of the exchange and improvement of average liquidity of the available listings will also help in strengthening the case for the IFC when having to negotiate about it with the other CARICOM nations. In and of itself we do believe that TT does have the potential to become an important factor in the region. But to get from potential to realization in what has to be political lobbying with about a dozen of other nations will only work when the first seeds are sown. The economy is interesting for Frontier standards, but we at Lodewijk Meijer are less convinced that the financial system is as interesting yet.

That is not to say that knowledgeable investors should avoid investment in the country, if they want to allocate to Frontier Markets. But, only if you really have expertise in the country and a long term outlook (because of the illiquid trading) a direct investment in the stock exchange could be considered. There are some investment fund opportunities available. But they are illiquid as well. The alternative is to buy a stake in a mix of Neal and Massy (proxying the oil / gas industry next to some other industries where they are active), ANSA McAL (itself also a diversfied portfolio) and one of the banks (Republic Bank) as reasonable portfolio following the fate of TT in its quest for regional economic leadership. 

Challenges for Frontier Investors

TT is not different from any other Frontier economy in this respect. Thin trading, unclarity about rules and regulations and a developing financial industry with probably on average still quite a bit to learn compared to standards at home are all factors that Western investors willing to invest in the country will have to deal with. But for a long term investor, carefully following the macroeconomic story and politics while closely working together with a local/regional specialist it might be worth the effort.

The world is changing. Emerging Markets are here to stay in the New World Order and selected Frontier Markets are definitely gemstones in the years to come. Those with a solid economic base or commodity reserves might be the first to benefit from the globalization of investment portfolios of Western pension plans and Sovereign Wealth Funds from other places on the globe. Although of course relatively small, TT’s role in the Caribbean might make it a valid building block within a Caribbean Frontier portfolio. We at Lodewijk Meijer will carefully watch developments for you.

The World is Changing: Also in Asset Management

Posted in Emerging Markets, Financial Markets, Manager Selection, Uncategorized with tags , , , , , on March 20, 2009 by evd101

By Erik L. van Dijk

The world is changing. On the one hand, we see that the relative importance of Emerging Markets is growing. When looking at the relative market value of stock markets of these nations, we see that the percentage went up to some 10-15 percent in 2006-07. True, due to the credit crisis this percentage dropped back to about 7-8 percent recently. And although that number is more or less in line with percentages seen in the decade before, one thing is totally different since 2003. Market values of stocks represent the price of economic activity in a country (albeit as a rude proxy). But the gross domestic product (GDP) of a country is an indicator of the underlying asset base / fair value of that economy. Robert Shiller’s excellent book on Market Volatility contains a few papers that clearly indicate that prices are far more volatile than fair value. Result: we move from periods in which prices are far too high to periods when they are more or less in line with fair value to periods when prices are way too low, et cetera. With the GDP weight of the Emerging Markets now being close to 30-35 percent of world GDP, it is obvious that the market value weight underestimates their current importance. More than ever so. We do therefore believe that the bulk of conclusions drawn by Jim O’Neil and his Goldman Sachs economic research team in their book ‘Brics and Beyond’ do still hold. This is going to be the era of Emerging Markets. Sooner or later China and maybe India will be bigger economies than the US one.

But it is not just the economic world that is changing geographically. A similar phenomenon is going on in the asset management world. As an asset manager selection specialist, I would say that up until the beginning of this century the bulk of real best-of-breed asset managers was Anglo-Saxon. Within that group, the US asset managers got the lion’s share. This was especially true when looking at so-called quantitative asset managers. In the fundamental zone there were some good British asset managers active as well. Local parties in other nations were mainly of interest to local end-investors to the extent that the local factors were of importance. Be it legally, or because of the local presence. In terms of performance track record they couldn’t keep up with the best-of-breed specialists from the UK and US.

Now, with the world getting smaller due to globalization, the number of products growing and international complexities increasing, something has happened. The dominance of the Anglo-Saxons in the best-of-breed major league is far less prominent than it used to be. In the case of the Americans part of this is understandable. The Americans were always best in domestic products, and I would still be more than surprised to see a top-notch US equities or bonds manager not being from the States. It can be done, but it is hard. But their attitude to label products elsewhere as ‘International’ and put them alltogether in one mandate/fund was illustrative of how the US saw the world: us, the US, versus the rest. In terms of a world divided by market cap this was actually quite understandable. The US’s relative weight in terms of market cap was indeed about 40-50 percent for many years. If you add to that the fact that the Wall Street stock markets were the best-regulated and most-liquid ones, this approach was more than OK.

But with the shift in economic activity, and with the world becoming a more equally-weighted place with the US now being approximately 30-35 percent of the total pie, Europe and other developed nations (JAP, CAN, AUS, NZL, SING, HKG) representing a similar percentage and the Emerging Markets also, things are changing. And not just that, it is also clear that with this shift in economic power two important trends have helped to change the balance of power in asset management:

  1. The increasing role of London as center for international asset management. With Americans being less internationally-oriented than the Brits, major banks, insurance firms and asset managers from all over the world realized that London was an excellent alternative as world hub for international mandates. Not just in terms of available knowledge, but also in terms of time zone, being neatly placed between Asian time zones and the US time zones. The UK also followed an active strategy to grow the London Stock Exchange and attract as much as it could this type of new business. And with it came the shift of knowledge to this market. Even big American institutional investors and financial services firms accepted it and the growth in the City of London was to a large extent caused by American institutions understanding that ‘London was the place to be’ for non-US asset management. It was not surprising that the brightest talents in the asset management community followed this trend. Sure, when thinking in terms of academic study in Finance or Investments the US was still the hottest place to be, although levels in European schools like the London Business School, London School of Economics, INSEAD or even Asian ones like the Indian Institutes of Technology, top universities in Israel, Hong Kong and Singapore are definitely not considered much lower by recruiters anymore.
  2. And not just that. With the economic balance of power shifting, it became clear that there were areas of the market in which foreigners could do at least as good a job as their American colleagues. The ‘investment game’ is not the same in every asset class. Equities, Fixed Income, Hedge Funds are different games. And that is definitely true when looking at running portfolios of securities in these markets in different countries. This has led to the rise of excellent asset managers in other nations as well, also on a performance basis.

Examples: the top-level French asset managers are true specialists in Fixed Income. Somehow the French specialists, often relatively quant-oriented play a ‘game’ in Fixed Income that makes it very hard for the big Americans to compete. Germans also are strong in Fixed Income. Good quantitative managers are now also not a rare thing in the UK anymore, albeit that it is mainly in boutiques (with the exception of large powerhouse Barclays Global Investors, albeit that BGI is especially strong in index products). Average knowledge levels in the Netherlands and Scandinavia have gone up spectacularly.

This increased competition between a growing number of international players with far more knowledge dissemination than before has led to:

a) growing numbers of strong asset management boutiques, that exploit a specific, specialized skill set on a relatively narrow market segment;

b) finally (!), some downward price pressure on asset management fees, with unfortunately brokerage fees still not following quickly enough

c) the demise of parties that didn’t really add value, but simply leveraged their ‘brand name’ image / ‘size’

d) a growing interest in manager selection, because – with the non-existence of reliable ratings similar to what we described about rating systems in the Chess World in a previous entry – a larger number of providers in a growing number of sub-categories of asset management made things less overseeable for the average investor.

That is where we stand. An industry getting more mature at a time when the financial world seems to be burning. Investors do not just have to analyze carefully which asset manager has products in a specific category that are truly outperforming on the basis of skill, no, he/she also has to make sure that the provider itself will be there one year from now. Especially asset managers that are part of large banks or insurance firms have to be analyzed carefully. Before you know the asset management operation is sold as part of the restructuring operation, with all the turmoil that goes with it. What will that do to the team of specialists that you think you are hiring when opting for a specific product that you like? Will they stay with the entity? Leave to another one? Start their own?

Asset management in a grown-up financial world is more important than ever, but separating the good guys from the bad ones will itself prove to be a new, specialized quality as well. A quality that can make or break overall portfolio results. Those of you that were hurt by investments in the Madoffs of this world, or in asset management products that underperformed indices by 100s of basis points know what I talk about.

The end result of this new development is of course good: they are all signs of maturing. But as long as end-investors do not realize what is going on and think that the old world is still there, it will take quite some time before end-users – be they pension plans or private investors – will be provided with a full opportunity set of good products, with bad products having no chance at all. In the mean time the grey zone will continue to make victims, because penny-wise, pound-foolish market participants might continue to follow a DIY strategy of selection without realizing that it is really true that results in the past are not necessarily in-and-of-itself indicators of success in the future.

What we can learn from the Credit Crisis

Posted in Asset Allocation, Emerging Markets with tags , , , , , on March 6, 2009 by evd101

By Erik L. van Dijk


On Feb 11, 2009 one the brighest minds in asset allocation, Robert Arnott, gave an interview to US market information provider Morningstar. Arnott, the founder/former CEO of First Quadrant, a firm specializing in asset allocation strategies, made a few things clear:

1) As we already knew from earlier work from French scholar Prof. Bruno Solnik, the only thing that will certainly go up in a period of crisis is global correlation levels. With the exception of maybe gold and frontier markets that are truly secluded – like for instance the IR Iran, the topic of our previous post – everything will one way or another be hurt. Even the Fixed Income markets are not really providing investors with a safe alternative in a period when panic strikes, risk premiums go up and even the safest of the safe end up in big turmoil. The developments in the financial sector were indicative in this respect.

2) When looking at a Diversification 101 lesson that can be learned from our own Harry Markowitz’ s work, or from any MBA text book, the basic idea ‘Stocks for the long run, and Fixed Income and other securities for the periods in between when stocks are not delivering’ is fine. However, we should never forget to define our risk budget in a clear way and above all: stick to it.

3) With respect to 2): the lesson to be learned from Behavioral Finance is that people tend to overestimate their skills in good times, and then – when disappointed – turn to a kind of total disbelief in their own or other’s skills. The outbreak of panic that will follow can lead to disasters, similar to what can be seen in tragic accidents in football or soccer stadiums, when a little fire can cause many deaths in the audience. Not because of the fire itself, but because – in panic – most people want to leave via the same exit. It is the stampede that follows that kills, not the fire. Actually: if all those people running away from the scene would have joined forces, take of their jackets and throw them on the fire it is quite certain that the problem would be solved. The big killer in the crisis is the actions/trades of the ones in panic.

4) So basically, what will happen then, when markets slide into an enormous downfall because of the massive sell-off of shares with all ‘smart’ loss-takers thinking the same smart thing at the same time – as a result of which it is not that smart anymore – is that a situation is created in which smart money can earn a lot. Real winners are made in periods of crisis, not in normal periods. However, when everybody gets crazy and the savvy hold their breath and wait for the bottom level of the market to arise, we should be aware of the fact that the best investors that want to wither the storms by telling their followers that markets are exaggerating will look just as wrong as bad investors do in a normal period. Distinguishing between a top-level investor and an idiot becomes harder in a crisis period.

5) And there will be chances, a lot. Especially further from home, in niche markets that are allegedly risky in the eyes of the global investment community. It is a given that both private and institutional investors tend to have a stronger home bias in crisis times than in other periods. Result: the sell-off was largest in the Emerging and Frontier markets, notwithstanding the fact that economic growth numbers in these markets were not as bad as those in the West. And this is especially strange when also taking into account that these countries have a much smaller percentage of their market cap weights in financials, the sector were it all begun in the 2007/08 (and maybe 09?) market meltdown. I am sure that there will be blue chip investment opportunities in market leaders in Emerging Markets at a price of 3-5 times earnings. PE’s that low do not make sense, and neither does the  fact that the global market cap weight of Emerging Markets is down to 7 percent, a similar level as before the 1997-98 Emerging Market crisis. Things are really different in these countries this time around. China, India, Brazil and Russia (the BRIC nations) are big players now with solid economic home bases, notwithstanding their short term problems because of the crisis. Oil and gas prices are higher than back then and will definitely go up again to levels that might not be as high as what they were last year, but still.

6) But now we have another problem that haunts us. It is risk budgeting related. Institutional investors work with risk budgets, and they should. The ones that apply this technique in a prudent way and directly link it into their asset liability modelling should actually apply the technique in such a way that they do – as an average over the cycle – take a bit more risk when prices are low and less when prices are high. Unfortunately, we often see the opposite. Above average risk taking in times of positive momentum and high stock price levels and below average risk taking when prices are low. Reason being primarily that it is easier to convince the board to allow more risk when you can show nice, upwardly pointing stock price graphs than when you see disastrous graphs with share prices going down, lots of firms going bankrupt et cetera. Psychologically, investment specialists in the pension plan community are normally not fired when buying stocks with nice track records too high (”How could I have known that some kind of change of fortune was on its way? All colleagues were buying this stock too!”), but when something goes wrong with their investment advice when things are going down the drain, the risk of being fired is much higher. This kind of people risk, is a behavioral factor that is still playing an important role in day-to-day institutional money management. Actually, a much bigger role than it should.

7) Now, the problem with market extremes is the following. A simple mathematical exercise will provide you with a clear example:

When prices drop 10 percent (from 100 to 90), we need an 11 percent (10/90) increase to be back at the 100 level. When prices drop 20 percent (from 100 to 80) we need a 25 percent increase (20/80) to be back at the 100 level. When prices drop 50 percent (from 100 to 50) we need a 100 percent increase (50/50) to get back to the 100 level, et cetera.

In other words: the rebound of a market has to be bigger the bigger the crisis is. And the current one was and is big.

8 ) Now, another characteristic of crisis periods is that most risk indicators – like market volatility – go up tremendously. Often to levels 50 or more percent higher than normal. This will imply that market participants that are willing and able to take the plunge and act countercyclically to be among the first to benefit from the crisis will need big risk budgets to benefit. And often, besides being counterintuitive because of the personal risk involved, they don’t have space for that after the calamities that have happened during the crisis.

9) This will in turn imply that two things are really important during the recovery period after a crisis:

9a) Try to find recovery opportunites that add as little additional risk to your portfolio as possible. That is why actually some frontier markets might be of extreme interest (low correlations; compare Iran in our previous post), or asset classes that normally get a relatively low weight.

9b) Buy quality for the longer run. One of the characteristics of a crisis is that people in panic don’t care about anything anymore. For them shares are not securities that entitle them to a share in the firm’s profit, but lottery tickets or casino games that only cost them money. And not just that, they are financial instruments that embarrass them. Sell, sell, sell! But this implies that – when the crisis reaches its end – the battle field will be full with quality firms with now amazingly high dividend yiels (often many times higher than the interest rates available in the market), low PEs and huge potential for growth in the years ahead of us. These strong firms will have themselves nice opportunities to acquire struggling colleagues so as to stimulate revenue growth further, et cetera. In other words: it is the period when the difference between growth and value stocks, and growth and value markets is smaller than ever. Use that fact.

10) Are guys like Arnott and ourselves optimists? Nope, we are just the ‘boring guys’ (Harry Markowitz once used this phrase). Most people – be they institutional or private investors – don’t like what we do in good times (since we don’t take enough risk and are not willing to pay 50-100 times earnings for great momentum stocks in IT, Biotech et cetera) and neither do they like our relative calmness in periods of collapse and crisis. This is not the end of the world, just the end of momentum hunters that went in too late when markets were going up, and now go out too quickly when markets go down. Since we do not know exactly when the shift into upwardly trending markets will be there, it is quite well possible that we will be too early. If that is the case, we will loose a bit before we will win. That is the price of being a smart asset allocator: people will not really like you in the upward phase of a cycle and neither will they in a crisis period. They will only love you over the whole cycle, and even more so over more cycles. This is about sticking to a long-term rational philosophy in which the technique of how to do things is universal and eternal. The individual stocks, asset classes, countries that we like and don’t like do however change, because they will be going through phases. Paul Kennedy’s book The Rise and Fall of the Great Powers gives a good example of how this same line of reasoning applies in history and politics as well.

11) Last but not least: it is not the end of the world. The growing opportunity set is already visible. Be prepared – if and only if you do have space in your risk budget – to try something, but be also prepared to buy things you didn’t buy before. Fundamental indexing is an interesting tool to help you now. Analyzing the difference between stock markets based on market value weights vis-a-vis fundamental weights based on PE, PC, PB, dividend yield, earnings growth and/or revenues might reveal easily where the opportunities are. At the same token, we should concentrate again on Emerging Markets: the fundamental weights of this part of the world are indeed already in the 30-35 percent area with market cap weights now as low as 5-10 percent. That is a huge mismatch. In other words: due to behavioral factors too much money flew back into Western stock markets or savings accounts when things went wrong. Now, with rock-bottom stock price levels and interest rates, it might be worth the effort to look for the true gem stones in the emerging markets. But, never ever forget the risk budget. And the old Markowitz diversifications lessons: when understanding that Gazprom in Russia is now really to cheap, don’t put all available equity money in that stock but add the best opportunity in an country/industry least correlated with Russia and Oil/Gas that also provides you with a quality bet. Optimization and risk management become more important in a period like the one immediately after the crisis, because a good approach in that area will help you recover quicker with relatively less risk which will improve the return/risk profile of the portfolio substantially. And that is really necesssary after the disaster of the crisis period that has just ended.

For the full 4-5 minute interview of Arnott with Morningstar CLICK HERE.

Iran; the neglected country effect

Posted in Emerging Markets with tags , , , , on March 5, 2009 by evd101

 By Erik L. van Dijk

Yesterday, March 4 2009, I spoke at the Emerging Markets Fund Forum in London. I spoke on behalf of our own firm and on behalf of AMIO, a non-governmental Iranian trade organization. Topic: ‘Will IR Iran realise its potential as one of the world’s largest frontier economies?”. It is strange to see how my partly coincidental, and partly logical association with this country has moved me from a situation in which people didn’t want to hear about it at all, to it now being probably the hottest niche area within our business model.

The association was partly coincidental in that I met the AMIO president at a conference of the World Chess Federation, FIDE. Dr. Madahi is president of the Iranian Chess Federation as well, and when we met I was the representative of the Dutch Chess Federation. It is always good to meet face-to-face and understand what moves the people involved with specific matters. At first we discussed chess, but when dr Madahi explained what AMIO stood for it was clear that our business contact would evolve further. AMIO = Agriculture, Industry and Mining Organization is a kind of Chamber of Commerce for the non-energy sector of Iran. From our side, the interest in various countries around the world and their investment potential was directly related to the asset allocation work that goes back to my cooperation with Noble Prize laureate Dr Harry Markowitz. I think that we basically did two things right during the last 10 years when working on the approach: 1) Its optimization and risk management framework was an improvement compared to the old Markowitz work; and 2) being the old academic I was, I went through the toil and trouble to add basically all countries we could get data for. So now we have a system with almost 100 countries included, based on a proven approach. With respect to the latter, I refer the reader to the CFA Webcast done by Seb Page of State Street in cooperation with MIT professor Mark Kritzman. It is always better when others explain something that you did, especially when they consider it one of the better things around in this area. And not just that: Page did a tremendous job in making something mathematical perfectly understandable for decision takers and other interested readers without strong econometric background. Harry and I wouldn’t probably be capable of cutting the math as much as Page and Kritzman did.

Now, back to Iran and Emerging Markets in general. Initially, around the turn of the century, people frowned or laughed asking us why we included so many countries. Wasn’t it true that liquidity was only large enough in let’s say the first 10-15 or so? True, but times have changed (and so did oil prices). We have learned a lot about a new world order, in which BRIC nations would be the new catalysts for global growth because of their economic power on the one hand, and sovereign wealth funds (SWFs) that would finance the same world due to their oil or gas wealth on the other hand.

So, when the credit crisis hit hard, and Western leaders started to find a way of coping with it, they didn’t really seem to capture completely what was going on. Or they did, and didn’t want to tell us. The credit crisis was NOT a liquidity crisis at the global level. Globally, liquidity that once flew between Europe and the United States, has been transferred to selected Emerging Markets that did not automatically transfer money back to the Wall Street NYSE stock exchange.

That was what Europe and the US were doing in the past. People in Europe were careful, prudent, saving. In as far as they were investing, their stock markets were small, underdeveloped and their firms often not as strong as the US power houses. Result: the consumption excesses in the US were fed by a European money inflow to Wall Street. And whenever firms in Old Europe were struggling, there were always the big US market leaders providing them with capital or buying them so that this system could continue.

But, that was a stable system based on a market value oriented global economy. The US was 50 percent of that world, Europe and Japan some 35-40 percent and the Emerging economies completed things with 10-15 percent. The latter group was too small to have any major impact. Only exception was the 1971/72-1974/75 period when the world suffered from the first oil crisis and leaders in many western countries got scared that the Arabs would take over their world. But the fears vanished and we turned back to our old world order in which Europe and the US led the world.

At some point in time there were fears in the US that the Japanese would take over when the market value of the Japanese stock exchange turned almost as high as that of Wall Street. But it was exuberrance.  And again, we turned back to the old world order.

But it is really different this time around. The globalized world should be analyzed on the basis of GDP weights and not market capitalization weights. When looking at gross domestic product, we see that the US is closer to 33% than to 50%, like it is in the market cap weighted world. Europe – Japan is also about one-third of the GDP-weighed world. But the Emerging Markets are now also about that large. Obviously, when three areas are equally important economically, why then be surprised that they do have equal importance when trying to cope with the credit crisis as well? So far, Western leaders and finance ministers seem to be talking with and to each other, forgetting about all this. Maybe with one exception, Gordon Brown, who visited the Middle East because he understood that that is where (a large part of) the money is.

Whereas the Japanese basically didn’t have enough people to challenge the US, which meant that their labor productivity would have to grow to unsustainable levels, the Chinese in combination with other Emerging Markets do. Western populations – and probably in due time also the Chinese population itself – are not growing anymore in numbers. No, they are just growing older. This has led Goldman Sachs to come up with research that indicated a list of the so-called Next-11 countries with the most potential. Iran is one of them, with a population of 70 million and probably one of the lowest median ages around: 26.4 years for the average Iranian. In other words: the bulk of Iranians never lived in the old Shah period. What makes us think that the majority of people in a country that showed good growth rates and has free borders (Iranians can leave the country; or travel back, like many of the Iranians now living in the US or Europe do for holidays, family visits etc.) will be totally focused on shifting back to a regime similar to the one of the Shah? An Islamic Republic with the stability of IR Iran cannot be possible if your answer is: the majority. So I guess that if you stick to that answer, it has to be augmented into: the majority of Iranians abroad. If that is the case: fine with me!  A survey of Dutch pensionados living in Spain will probably also lead to the result that the bulk of them don’t like today’s Netherlands anymore.

But: if Iranians in Iran would think the same way, no way that the stability and growth record that they achieved after the first 10 years of the revolution when the country had to be rebuilt and it had to cope with the 8-year Iran-Iraq war, could have been achieved. Crime rates are relatively low, oil and gas income grew to enormous levels and the Tehran Stock Exchange did reasonably well during the crisis. So well, that Iran even succeeded in privatizing the majority of Telecom Iran (TCI) during 2008! TCI was immediately – by far- the largest individual firm on the Tehran Stock Exchange with a market cap weight of approximately 15 percent. An economy has to be very rich and strong when it can cope with an IPO of 15 percent of the size of the whole market in the middle of a credit crisis.

In my presentation yesterday, I also added a little demagogic exercise. What is the value of proven oil and gas reserves of Iran against today’s market prices? Answer: the whole population could take a 30 year holiday (all of them!) when we assume that the difference between today’s oil and gas prices (which are relatively low due to the crisis) and the average over the next 30 years is enough to pay for extraction and workers to do their jobs.

If we add to that that their banking system – based on Shariah – did not suffer from the leverage-driven problems faced by their Western counterparts, one can imagine that we are talking about a real potential powerhouse here. Now, when we don’t allow dialogue or trade with this powerhouse at a reasonable level, what will happen is the following:

1) We are hurting ourselves more than we hurt them;

2) If we think that Iran is associated with terrorism. do we really believe that the likelihood of this going down due to some embargo is high? This was a rhetoric question.

Wouldn’t it be much better to do business together and have dialogues? We need Iran, and they need us. The latter applies in areas like knowledge transfer and investment opportunities for their wealth funds just as much as for entrepreneurs that want to do business in the West. It is good to see that the Obama administration understands this. I am sure that Larry Summers, his chief economic advisor is at least to some part making this dialogue plea as well. And of course, some people might say that it is still all theory. Will Obama really change things? Is there any proof yet? I think there is: two days ago the Dutch financial news paper showed a picture of Akbar Hashemi Rafsanjani, the former president of Iran and today’s leader of the Assembly of Experts of the country, visited the Iraqi president Talabani in Baghdad! Iraq is still controled by the Americans. No way, that an Iranian leader as important as mister Rafsanjani could travel to Iraq to talk about helping in the restructuring of Iraq without some kind of harder indication that the Americans do want to work together and are serious about dialogue.

So here we are: the biggest frontier market of all, more or less neglected by investors. This leads to a tremendous opportunity. The Iranians are ready for it, and as my experience during the last year indicates, growing numbers of investors and other market specialists feel the same. Before people made me believe that my acquaintance and now association with AMIO was something ”obscure”, but now they consider it one of the main pilars in our business model.

So yes, the world is changing. With markets now at rock bottom level, what will probably happen is the following. The Chinese, the Arabs and the Persians will first buy themselves – either directly or indirectly – into Western stock markets. The amount of money that will flow to our markets will exceed traffic the other way round. But, with the opportunities in Iran, the Gulf States, Asia, Turkey and even Africa sooner or later the net balance will flow from here to there. That is the mid-term. In the long-term we should get ready for a new world order in which indeed China will take the lead.

I hope that my presentation on Iran will be of help to you. For the full presentation CLICK HERE.