Risk in emerging markets and beyond
Jerome Booth’s book, despite its title, is not really about emerging markets. It is, rather, an overview of the deep flaws that are currently inherent in the intellectual framework that underpins the existing free market system – in particular economic policy and investor behaviour based on the edifice of financial economics and modern portfolio theory. He argues that this has caused risk to be misinterpreted and under-perceived in the developed world and investors are being imprudent by over-investing in developed countries and under-investing in the emerging world. The book strips away the prejudices, assumptions and misconceptions that lie behind much of what is deemed as financial economics which, he argues, is perfectly useless – and the practical application of which is wrong, unfit and has created distortion in asset-allocation on a global scale. Booth’s belief that this has adversely affected millions of peoples’ lives and has to change is the theme that underlies this work.
His strong view is that investment in emerging markets has been dogged by prejudice – a feature he attempts to highlight by defining emerging markets as countries where risk is recognised and priced in. The 2008 credit crunch was a turning point for the global economy not only in its immediate impact, but also by the fact that it demonstrated the very shaky foundations of the current international economic environment, whose fundamental problems have been merely hidden by the impact of quantitative easing. Booth, not surprisingly, given his previous role as head of research at Ashmore, makes the case strongly for emerging market debt, portfolios of which he sees as vastly superior to the debt of what he describes as HIDCs (heavily indebted developed countries).
That the economic environment we live in is unstable is clear, given the experience of the past seven years. But Booth argues that there has been failure to undertake the steps required to make it more stable as a result of deeply ingrained prejudices and failures by policy makers as well as by the intellectual underpinnings of institutional investment. Booth argues that macro-economic theory has been led astray through rational expectations theory, which underpins key ideas of modern portfolio theory, such as the efficient market hypothesis and the capital asset pricing model. Yet, as Keynes had pointed out, there is a difference between risk, which is something that can be estimated given probability distributions, and uncertainty, which implies a lack of knowledge, giving rise to a lack of confidence to invest. Moreover, defining risk as the volatility of asset returns gives rise to distortions when what matters to most investors is the impact of realised losses, rather than fluctuations in valuations. In this respect, behavioural finance can have a part to play. The edifice of asset allocation based on assessments of risks and historical correlations using cap-weighted indices as proxies for asset class behaviour falls apart, particularly when applied to emerging markets. Indices that weight countries according to debt issued are riskier than active portfolios which are based on analysis; rating agencies suffer from a bias against poorer countries, whilst investor perceptions of risk can be confused.
What Booth’s book achieves is to open a Pandora’s Box of issues that could stimulate the marketplace to seriously question many of its fundamental beliefs. What it lacks is detailed answers and policy prescriptions. But if it can provoke the next generation of finance and economics students, investors and policy makers to seek answers to the issues it raises, then this excellent book is surely worth a place on their bookshelves.