No Free Lunch in Emerging Markets

In the early 1990s, investors began pouring money into emerging stock markets such as Thailand, Indonesia, and Chile. Market watchers dubbed stocks in these burgeoning markets a "free lunch" because they offered both robust returns and a means to diversify and reduce risk in stock portfolios. These tiny emerging markets did not ride the waves of bourses in developed countries, thereby providing a hedge against drops in larger markets. But the recent dives in Asian stock markets beg the question: Is there ever really a free lunch? Associate Professor of Finance Geert Bekaert thinks not--at least not any more.
       Bekaert, who has completed several research studies on emerging markets, believes the free lunch doctrine has limited relevance for many global investors today for two reasons. First, Bekaert found that the data used to track emerging market stocks do not necessarily give a true picture of the returns available to global investors. After examining widely used data from the International Finance Corporation (IFC), an institution dedicated to promoting private investment in less developed countries, Bekaert discovered that the diversification benefits of emerging market stocks were less than the IFC information indicated.
       Working with Morgan Stanley associate Michael Urias, PhD '95, Bekaert found the IFC figures did not always factor in crucial data. In Thailand, for example, different prices apply to foreigners, who must trade restricted stock on an alien board, yet IFC data are based on Thailand's main board, where only domestic investors trade. In Chile, foreign investors are restricted from repatriating capital for one year after investments are made. In Argentina, among other countries, foreign investors pay much more to trade stocks than they do in developed markets. Furthermore, special transaction fees, poor liquidity, currency, and macroeconomic instability can impact performance in ways not necessarily reflected by the IFC numbers.
       Second, Bekaert notes that many of these markets have matured out of their super-heated, early-stage growth where the rush of foreign investment has driven up stock prices. "They aren't emerging markets anymore," says Bekaert. "They've emerged." The flow of money into exotic markets has been made possible by new investment vehicles that make buying and selling in faraway places easy even for rookie investors. They include closed-end mutual funds, open-end funds, and American depositary receipts (ADRs), which allow individual investors to trade certain foreign stocks in the United States.
       Although restrictions and costs will decline as global market integration accelerates, returns relative to developed markets are likely to fall. The benefits of risk reduction and diversification also may diminish as maturing markets begin to move in tandem with New York and London. In a related study with Duke University finance professor Campbell Harvey, Bekaert noted that as emerging markets liberalized and opened up more to foreign investment, there was a slight reduction in expected returns. Although the effect was small, they also found that these small markets began to move more in step with other world markets.
       Nevertheless, foreign money is still flowing into emerging markets. Developing countries welcome the shift from the loan money of the 1970s to the risk-sharing capital of equity investment. At the same time, growing pools of U.S. mutual fund money continue to seek new outlets. Few American investment banks are without an emerging markets research desk, and all have invested heavily in providing investors with outlets such as specialized mutual funds. "They have billions of dollars of institutional money that wants to be in emerging markets," says Bekaert. Even conservative U.S. pension funds have started to look at foreign investment as a way to diversify portfolios in the face of the long-running U.S. bull market.
       There are still opportunities for diversification, but investors shouldn't expect these markets to be priced as they were six years ago. Bekaert suggests it may also be useful to stratify markets according to their size and expected growth. Malaysia, for example, should no longer be classified as emerging since its economy is well developed. The bottom line: Emerging markets will most likely remain part of a diversified, international portfolio, but don't use history as a guide when placing future bets.
---BB

"Is There a Free Lunch in Emerging Market Investing?" Geert Bekaert and Michael Urias, GSB Research Paper #1442, July 1997

"Diversification, Integration and Emerging Market Closed-End Funds," Geert Bekaert and Michael S. Urias, The Journal of Finance, Vol. LI, No. 3, July 1996