The key investor concern is the volatility of emerging market currencies, which is likely to be an important influence on equity returns for investors with serious exposures in these countries. They are right to be concerned about this, says
Harvard University professor Kenneth Froot. While the currencies have been extremely important during the time of crisis in the Asian economies, “we are still seeing less systematic movements across these currencies, but still large movements. A large amount of uncertainty has to be resolved on the exchange rate side. So the dollar equity values are being pretty strongly influenced by what is happening with the currencies.”
As to how to cope with this, one of the key ways, he reckons is to look into programs to manage the currency risk separate from the equity exposures themselves. “Most equity managers have a very episodic and non-programmatic approach to dealing with the currency components. Sometimes they will buy or sell currencies, but there is not a systematic approach to understanding when bad information is already priced in the market and when it is not.”
A modified overlay program will give opportunities to operate some returns from “this asset class”, as Froot, who is managing director of Emerging Markets Finance in the US, a member firm of State Street Associates, considers the emerging currencies to be. “We actually think that as a policy variable, these emerging market currencies are somewhat manipulated by governments in pursuit of conflicting policy goals. The implications are that this gives opportunities to trade these actively, in addition to the overlay itself.” The combination can be one of risk management in the overlay, plus looking to the return upside from active management, he says. “Significant returns relative to risk can be obtained on the active side. These returns can be up to two times the amount of the risk generated by the active process itself.”
One of the most surprising features of the emerging market scene, in his view, is that despite the fact there has been such significant changes, the structure of the markets remains the same. “There has been a world of change in the character of trading, but the policy relationships that dictate these variables is actually very similar to what it has always been. One of the things that shocks us is the extent to which the exploitability by investors of these ‘policy conflicts’ has not changed very significantly over time.”
He cites the example of a country experiencing a capital outflow, which is then faced with the choice of raising interest rates or letting reserves reduce. But putting interest rates up has the effect of causing a recession, while keeping inflation low. Letting reserves flow out is less of a tightening of the economy, but can lead to higher inflation and threatens the external value of the currency much more. “These are the choices that policymakers have to make all the time in relation to capital outflows and inflows,” says Froot. “One of the things we do in assessing the kind of choices – are they going to choose stability of competitiveness. We study in detail these cross-border flows, as they have a very important effect on the liquidity of domestic markets and the issues central bank has to work with.”
In reality it is much more complex than that, because of political and other considerations. “You can see the political process working, we know the election cycles and so on. Often there are adjustments that need to be made in the economy, but cannot be made during certain periods of time, so the decision is more or less a foregone conclusion.”
Froot does not see scenario change much as the emerging markets develop and become more sophisticated. “There is a pretty permanent conundrum that smaller sovereign states face, that their capital markets are small relative to the forces of global money sloshing around. So when people want to come into or out of the markets, it is a pretty substantial tide that government has to cope with.” That he considers is unlikely to change, even if the currency was to be pegged to a stronger one, as it can still be subjected to that “tidal ebb and flow”, which means that the problems these still cause just show up in different ways, rather than disappear.
“Most countries try to go for somewhere in the middle, between a free variable which they don’t control as in a true float, or have it as a fixed variable beyond their control, as with a currency board. Most would like to have some options and end-up choosing something in between,” he says. While some emerging countries will undoubtedly join the dollar or Euro-zone, many countries will not and so face these fluctuations in their currencies. “What will drive the volatility of these currencies will be the capital inflows and outflows.”
He feels the currency issue puts the question squarely in front of the investors: “Anytime you see a substantial source of risk, you should be asking yourself how am I addressing that in my portfolio. Do I have a way of understanding and am I comfortable with how I am exploiting it and it is exploiting me?” The Asian crisis was a wake-up call and a reminder to investors that this had happened before, as during the 1980s. “These currencies are a substantial sources of risk in portfolios, they do influence returns and therefore it is worthwhile thinking this through in a programmatic kind of way.”
Some investors post the crisis were considering walking away from emerging markets “lock stock and barrel” , but now with good returns possible, they want to be there again, though with a clearer focus on what exactly they are doing when investing there, says Froot.
“Most of the equity managers do what they do well, but they should be sticking to their knitting and not focussing on the currency unless they have an a real avowed expertise. Stock picking requires a very different set of skills to understanding the country-wide currency phenomena.” Asset managers need to invest in both skill sets to do well on both counts, in his view. “Currently, there are more asset managers trying to address these questions in a more programmatic way, though the median manager is still a long way from that. Some have definitely tried to evolve their products along these lines for their own funds.”
“We find clients are looking for both the risk management aspects and to obtain returns from a more active alternatives. We reckon that US investors are less alert to the area, than say, Europeans, Canadians, and those investors based in emerging currencies, but the Asian crisis has woken them up more to the area.” But to put it into perspective, Froot estimates that probably only 10% or under of portfolios investing in emerging markets take proper account of the currency aspects of these investments. “The risks are as great as ever –- as are the opportunities!” Fennell Betson