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Rethinking Emerging Markets

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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The concept of an “emerging-markets asset class” may no longer be a sufficiently useful and accurate catch-all classification for investors.

The implications of this shift are important given the concept’s pervasive influence on asset allocation methodologies, benchmarking and even the way investment companies (and their service providers) are organized. The category also determines how allocators of capital review their portfolio decisions, especially at the beginning of a quarter.

To understand why EM may be losing it prominence as an analytical tool, let’s start with the three elements that typically define an asset class:

First, its components share similar characteristics: geographic location, for example, or much more importantly for investment purposes, economic and financial commonalities. These similarities allow the investments to be modeled relatively coherently for expected return, volatility and correlations with other asset classes. Yet these assets aren't so completely homogeneous that they can be replicated via a single instrument, which also opens the possibility of out-performance thanks to active management.

Second, the majority of the components of the asset class are sensitive to an external influence that is strong enough and sufficiently encompassing to have a similar impact across the board. This can take the form of a single variable, such as the price of oil for producers, or it can be linked to a policy, such as the effect of the European Central Bank's quantitative easing on sovereign bonds.

Third, the actions of investors impose a self-reinforcing consistency in the way individual elements of the asset class relate to one another. This could be the case, for example, when the bulk of investors use a predominantly top-down approach -- which takes into account the asset class as a whole rather than its individual components -- or when markets are overwhelmed by large tides of capital, be they inflows or outflows.

EM has grown markedly since its relatively modest beginnings, and it now contains far too much diversity to meet the first requirement of shared characteristics. It no longer qualifies for the second criterion, especially now that the comments and actions of a single policy-making body, such as the International Monetary Fund, don't move markets as they once did. The third characteristic -- the propensity of investors to look at such an asset class as a unit rather than as the sum of its parts -- still plays a role, giving rise to interesting dynamics.

Macro decisions to allocate or withdraw capital from EM – particularly through index and index-like vehicles --tend to be significant drivers of return, volatility and correlation behaviors, which too often leads to valuations that are decoupled from individual fundamentals. The resulting overshoots – on the way up or down – generate risks and opportunities not just for investors but also for the issuers of securities they transact in.

It is important to note that these distortions aren't caused by irrationality or malfunctioning markets. Instead, they reflect the evolution of an asset class that, at its inception, was underpinned by investor behaviors devised around common economic and financial attributes. It has since failed to keep pace with the increasingly diversified and divergent realities on the ground.

In the case of EM, this phenomenon is amplified as the market influence of a relatively small base of dedicated investors is subject to the vagaries of less well-informed “crossover” funds (that is “tourist” capital that, rather than being attracted by the attributes of the asset class itself, is driven to invest by fluctuating circumstances at home, and thus is far less stable).

As a result, both investors and issuers should expect valuations to continue to decouple for more prolonged periods than would be warranted by fundamentals. They also need to attach bigger margins of error to their predictions for risk-adjusted expected returns and, in the case of borrowers, the cost of capital and ease of issuance.

With long-term strategic positioning in mind, investors also need to take a more tactical approach to managing their exposures in relation to their fundamentally-based strategic portfolios. Borrowers should do the same when issuing new bonds.

Today, this means recognizing that EM is in a technical phase of unsettling volatility. It also means that individual components of the asset class will tend to trade cheaply relative to intrinsic values. Meanwhile, investor attitudes will tend to be overly influenced by news, for better and worse, from a few big markets (Brazil and Russia come to mind) as well as by the impact of advanced country central banks on the flow of tourist capital. Solid markets will at times be contaminated by the broader trends, even when their fundamentals are good. And the temptation to purchase the EM asset class via passive benchmarks will negate some important fundamental differentiation that is sure to emerge down the road and become an important contributor to superior performance.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Max Berley at mberley@bloomberg.net