The “R” Word in Emerging Markets
No matter what decision we face in our lives, there is always some type of risk involved. Even something as simple as trying a new food carries the risk of indigestion, whereas not trying it could mean missing out on a new taste sensation. Commit to a decision and you run the risk of it having been the wrong one. Fail to commit to a decision and run the risk of watching a success pass you by. So how do you know when to jump in and when to hold back? If you’ve read this blog more than once you probably already know what we think the answer is: roll up your sleeves and do the homework!
An educated approach is crucial to help determine whether the potential reward outweighs the potential risk of any given choice. Every investment decision carries unique risks, and while many investors think of emerging markets as a risky place to invest, a look at what’s happening in the eurozone right now proves just how dynamic risk can be. Close monitoring on a country-by-country, and company-by-company basis is crucial.
Mark Mobius, Executive Chairman of Templeton Emerging Markets Group and Wylie Tollette, Senior Vice President and Director of Performance Analysis and Investment Risk at Franklin Templeton Investments, are certainly aware of the risks involved in investing. And fortunately for them, they have the distinct advantage of identifying and monitoring these risks from the ground level. First, Mobius shares his observations of a few key risks that emerging markets in particular face, but at times apply to developed markets too: Political Risk, Volatility, Liquidity and Currency Risk.
Mark Mobius on Political Risk
“Investors may be quick to associate political risk with emerging or frontier markets, but every country in the world faces some degree of political risk. When administrations change, for instance, policies can change, affecting the investment landscape and market outcomes. Sometimes these changes can be a good thing. Recent events such as the “Arab spring” in northern Africa and the Middle East in 2011 and the post-election reforms in Myanmar this year could bring investors interesting new opportunities.
As I regularly visit countries many investors would deem “risky” due to an unstable political climate, people often ask me about it. I have referenced Pakistan as an example of why many investors have a heightened perception of political risk in emerging markets. Headlines coming out of Pakistan could easily lead investors to flee. However, sometimes the media can make a situation appear worse than it really is, creating a cycle of negative investor sentiment which can cause markets to decline further than, in many cases, we think company-specific fundamentals dictate.
That’s one of the reasons we visit so many countries, so we can see with our own eyes what’s going on. Visiting a factory or a mine, meeting with a company’s management team, and just talking to people on the street can provide a wealth of information beyond the headlines. As value investors, we believe market corrections based on fear can represent good opportunities to buy stocks at bargain levels. Despite the political challenges in Pakistan, we have invested in some companies there because we see attractive valuations and good growth prospects, and we will likely continue to invest there as long as we find good long-term opportunities.”
Mark Mobius on Volatility Risk
“Modern portfolio theory defines risk as volatility calculated by the variance (as measured by the correlation coefficient) of a portfolio’s historical returns. In simple terms, it means a portfolio that is yielding excellent returns may have a high risk profile, if those returns have been volatile over a span of years. Emerging markets can certainly be volatile, but then, so can developed markets. The financial crisis and subsequent credit crunch we saw in 2008-2009 stemmed from developed, not emerging, economies. And some of the developed countries currently grappling with debt problems in the eurozone certainly look riskier than some emerging markets, which generally have much lower debt-to-GDP ratios. For example, in 2011, Indonesia’s debt-to-GDP ratio stood at 24.5% while Italy’s hit a record of 120.1%.1 Food for thought.
The root cause of volatility is often uncertainty, which all too often leads to fear and over-reaction. Unforeseen circumstances can become catalysts for greater changes in the global landscape, and the markets have to continually adjust. The upside of this volatility for investors is that fear and panic can bring bargain prices for those with a long-term focus. The so-called “tequila crisis” in Mexico in 1994-1995, the “Ruble crisis” in Russia in 1998 and even the U.S. subprime crisis in 2008-2009 were examples of events that created dramatic market declines—and some great investment opportunities.
Liquidity (or rather, lack of liquidity) can play a key part in creating volatility, particularly in emerging markets. If there aren’t enough participants in the market and liquidity dries up, that can dramatically intensify a market correction. All markets have faced corrections, albeit some more severe than others. We cannot predict when the next correction will occur in any particular market and we accept that market volatility is simply a fact of investing life. I also believe that volatility could intensify as the use of derivatives and high frequency trading continue to expand, and markets become increasingly globalized. One way investors can help reduce volatility is through diversification by country, sector, and also by asset class. Diversification does not guarantee a profit or protect against a loss, however.”
Mark Mobius on Currency Risk
“Currency risk relates to the impact on an investment due to fluctuations in the national currency. We’ve seen many examples of currency crises throughout history (I’ve already mentioned a couple here).
So what does a currency devaluation mean to me as an investor? It doesn’t necessarily mean I’d be running for the exits. In some cases, a devalued currency can be an engine for future growth. A lower currency price means the nation’s exports will be more competitive (less expensive) in the global market, and imports will become more expensive, so many companies can benefit.
A discussion about currency values should include a discussion about inflation, which is closely interconnected. Inflation has been problematic for many emerging economies, and while it does seem to be ebbing temporarily in some markets, it’s important to remain vigilant about it. High inflation can cause a strong public response (even a mass uprising), as consumer purchasing power quickly erodes. As I’ve said in a previous blog post, it’s a delicate balance for many countries between stimulating growth and risking inflation.”
There is some confusion in the fund management industry regarding the word risk. It is used in two ways: (1) the possibility of losing your money and (2) the volatility of the investment price. Identifying and accepting the risks of a particular market that could result in a monetary loss is just one part of the investment process. Equally important is to study and develop a strategy for managing the second definition of risk, volatility risk, in a manner that supports one’s end goals. Wylie Tollette is part of the team that takes on this task at Franklin Templeton. He says simply being aware of and understanding volatility risk is a prudent place to start.
Wylie Tollette on Risk Management
“Investment risk management is fundamental to how Franklin Templeton manages assets and is consistent with our core values of putting clients first, building relationships, striving for quality results and working with integrity. Risk management is about ensuring risks are recognized, rational and have the opportunity to be rewarded—rather than being about “risk avoidance.” In other words, the purpose of risk management is not about eliminating risk or volatility, but insuring the risks we take are aligned with our investment convictions.
Our Integrated Risk Management approach builds risk considerations into each step of the investment process. The portfolio managers think about risk at the security level when they are evaluating individual stocks, and when they decide on the size of the position in the portfolio. The risk managers think about risk during the regular portfolio evaluation phase of the process, where each portfolio investment is evaluated for its contribution to risk and return, and overall diversification by our independent Portfolio Analysis and Investment Risk group. Top-quality risk software models are a part of the process and can help us better predict how the portfolio might perform—particularly during difficult markets. However, we think it is important to balance any model-driven analysis with “common sense” exposure and concentration review to ensure we have a comprehensive view of the possible outcomes.
Consistent with our conservative corporate philosophy, we use a comprehensive, integrated risk-management approach designed to determine whether investment risks are:
• Recognized—Risks should be recognized and understood at the security, portfolio and operational levels.
• Rational—Risk decisions should be an intended and rational part of each portfolio’s strategy.
• Rewarded—Every risk should have commensurate long-term reward potential.
An integrated approach to risk is part of every step in our investment management lifecycle.”
Want to know more? Find out what people had to say about risk and other investment concerns in Franklin Templeton’s 2012 Global Investor Sentiment Survey.
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What are the Risks?
All investments involve risks, including potential loss of principal. Generally, investors should be comfortable with fluctuation in the value of their investments, especially over the short term. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability, and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
1. Source: CIA World Factbook, 2011