Several weeks ago in this series I wrote about my belief that asset allocation frequently leads to two important unintended consequences: greater absolute levels of risk in investment portfolios, and deworsification, or too many assets in portfolios. In this edition, I want to address another dark, and unintended outcome of asset allocation, especially when it is productized. Specifically, how it impoverishes frontier and emerging markets.

Why Frontier and Emerging Markets?

In my 26-year investment management career there have been many times that I wanted to take advantage of the additional return and diversification opportunities of investing in frontier and emerging markets. It is a well known finding in the academic finance literature, for example, that there are efficient frontier advantages to doing so.

I am certainly not a modern portfolio theory adherent – being a more absolute returns and risk sort of investor – but believe there are strong reasons for investing outside of developed world economies.

The Bare Necessities

First of all, many investments in frontier and emerging markets are not about re-inventing the wheel. Instead it is about doing very basic things in the first place. Things like providing clean drinking water; paved roads; electricity; running water; cellular communications; schooling; access to rudimentary financial services, like checking accounts; and so on. In other words, these activities mostly just need a bit of political and economic stability, not a brilliant idea.

It is also the case that many of the investments needed in frontier and emerging markets may skip invention generations. I do not need to build a landline telephone network, I can skip straight ahead to later generations of telecommunications infrastructure. I do not need to build a sanitorium, and can instead go straight to modern medical technologies instead.

All of what I have just described means that there are return opportunities and for lower risk than can be had in the developed world. A paved road in Mynamar means much more there than it does in Ohio, USA, for example.

Innovations, Thank You

Another reason for investing in frontier and emerging markets is that some companies in these markets are doing things that are innovative and not being done elsewhere. Examples, historically, include micro-finance, portable solar cells to power a dwelling, and maybe even cryptocurrencies themselves (?). In other words, there is no hegemonic lock on human creativity. It may be that the most creative solution to a problem emerges, well, from an emerging or frontier economy. Duh!

Tie Breaker Altruism

One additional reason for investing in frontier and emerging markets is for altruism. I am not talking about outright, capital-destroying charity. I am talking about using the idea that $1 of additional capital goes much further in non-developed economies as a tie-breaker concept. If your return v. risk framework results in a tie-breaking situation, I would argue that that $1 of additional capital helps more people than it does in a developed market. In other words, how many of your financial models have ‘# of people served’ as a denominator? Using a tie-breaker criteria allows you to be a red-blooded capitalist same as always.

Getting It Right Is Expensive

All of what I described above exists within a fundamental framework where I exert a bottom-up, or top-down approach. Among my considerations are:

• The correct continent
• The correct country within the correct continent
• The correct industry in the correct country within the correct continent
• The correct business operating in the correct industry in the correct country within the correct continent
• The correct price paid for the correct business operating in the correct industry in the correct country within the correct continent

I roll up my sleeves and get to the hard work of carefully identifying these opportunities. All of this, is hard work, and expensive, too. I work harder to gather data, to translate that data into that which I may understand, and to assess that data. I travel further, spend more time in airports. I spend time learning things about local customs, regional politics, and nation-state politics. And on and on. Investing in frontier and emerging markets has alpha available, because of these difficulties.

For the sake of argument, let us say I get all of the above bullet-point list items done well. As a result, my portfolio’s doing great. There is alpha in excess of my expense ratio. My shareholders are happy. All is well. But wait, it isn’t really, is it? Why not?

Beggar Thy Poor Nations

My story above is incomplete isn’t it? The reason is that it doesn’t include the real world effects wrought on frontier and emerging markets by asset allocation investors. A quick example should be illustrative. In 2018 (and by no means is this the only such year from which we can pluck this example) frontier and emerging markets are selling off and suffering, why?

You can probably name some reasons why: Turkey’s Erdogan seems not to give a damn about the global business and political perception of his country and the lira is tanking; Argentina looks set to default again; interest rates are rising in the US, hurting the marginal investment case for emerging markets, and on and on.

My retort? What the heck does this have to do with the individual business and investment opportunity in Lusaka? [That’s in Zambia, Africa, for those that didn’t know.] In answering my own question, it has everything to do with the individual business and investment opportunity in Lusaka. Why?

Because ETFs, those slavish vehicles to those obsessed with asset allocation, invest in frontier and emerging markets, in the aggregate. So, if Erdogan makes a foolish statement it leads to a sell off of almost all frontier and emerging markets as people sell off their ETFs or other asset allocation investment vehicle.

In turn, this can hurt capital allocation to these markets for many years at a time, and having absolutely nothing to do with the individual company, in the individual industry, in the individual country, in the individual continent, but having everything to do with the price of a share in that same company. At the very least, the damage done to frontier and emerging market currencies is also extraordinarily damaging for the same reasons. Beggar thy poor nation!

This is how asset allocation impoverishes frontier and emerging markets. These products obviously were not established in service to impoverishment. Quite the contrary. They were set up to provide an investment vehicle for investors. Yea!

But look at the investment problem that is trying to be solved by most. Mostly asset allocation-using advisors are trying to get uncorrelated returns and risks to complement a domestic, or developed world, heavy investment portfolio and at a low-ish cost. The asset allocator could give two poos about what is going on in Lusaka, or to the kwacha. They don’t care about the returns of an individual security, or industry, or country, or continent. What they care about is that the returns to an entire asset class – frontier and emerging markets – are uncorrelated with the bulk of the portfolio. Yea!

Here are the Problems with that Thinking

The problem isn’t the desire to asset allocate or to seek out uncorrelated assets. Instead, the problems are:

• Frontier and emerging markets are not asset classes, they are individual securities within individual industries, within individual nations, within continents;
• Investment indices, served by products like frontier and emerging market ETFs, when bought and sold, allocate capital indiscriminately across whole swathes of people, their continents, their industries, and their companies
• Capital flows, when moving in huge, indiscriminate ways, affect currencies and impoverish people

Impoverishment occurs because the capital flows are not about returns on invested capital, they are not about economic growth, they are not about anything other than asset allocation philosophy divorced from reality. To me, this is another dark side of asset allocation. Before you get high and mighty about defending asset allocation, remember that financial services – our industry – does not serve 6 billion people on the planet. Another approach here is, rather than competing for an ever-shrinking-fee pie, why not grow the pie? Why not allocate capital to raising up those 6 billion people, thus creating 6 billion more customers? Oh, I know why, its because that is way harder than just executing a buy or sell for an ETF in your asset allocation strategy where your only concern was the directional sign of β.

I get it, I really do.

Jason A. Voss, CFA – Your Next Excellent Hire

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