Friday, March 28, 2014

Investment Advice from the World’s Largest Money Manager: Part 1

Investment Advice from the World’s Largest Money Manager: Part 1

Blackrock is the largest money manager in the world, with $4.3 trillion in assets under management.  In the last week, I’ve collected two interesting items issued by the firm. The first is a research piece issued by Blackrock Beta Research Group that makes the case for investing in the farthest reaches of the developing markets; places like Kenya, Lebanon, and Sri Lanka.[1]  Blackrock calls these countries the frontier markets.  The second item is a letter written by Blackrock’s chairman Laurence Fink to the chairmen or CEOs of every company in the S&P 500 urging them to resist the short-term orientation of activist investors.
Venn Diagram (2000)
Blackrock manages $1.7 trillion in index investments, $1.4 trillion in active strategies, and 0.9 trillion in exchange-traded funds.   When Mr. Fink speaks about corporate governance it is worth listening, because Blackrock holds $2.3 trillion in equities.[2]  Moreover, as an index manager Blackrock is truly a long-term investor whose sole instrument for affecting corporate behavior is proxy voting.  I’ll discuss Mr. Fink’s letter Monday.

The research paper, “Crossing the Frontier: Accessing new sources of growth and diversification with frontier markets” illustrates the distances to which investors have to go to find new sources of return and diversification.  Thirty years ago, US investors sought out the developed markets of Europe and Asia for a new source of investment and risk reduction.  About twenty years ago they pursued opportunities in the emerging markets for the same reasons.  Today any institutional or retail investor can quickly create exposure to foreign markets without giving it a second thought.  However, as these markets have become integrated into the global financial system, their returns and risk have become more correlated to the US markets.  In short, the benefits have faded as we’ve integrated these equity markets into our investible universe.

Blackrock has identified the next frontier, where expected growth rates and risk are high but where correlations (the relationships between those markets) are still low.  As Blackrock’s research shows, the currencies of these countries are relatively stable versus the dollar.  All of this makes for a very attractive investment opportunity.  And as long as we observe those markets and don’t try to invest in them, Blackrock’s research will look compelling.  I’ve included below two key charts from the research that illustrate the stability of their currencies versus the dollar and the low correlation between their markets.

However, these markets are relatively small, since most of their investment capital is either supplied locally or by very adventurous foreign investors.  What do you think happens when American, European, and Asian investors begin to pour money into index funds, ETFs and active strategies targeting frontier markets?  Invariably, the correlations will begin to rise as the capital inflows wash through those markets.  In addition, the currencies will begin to swing because foreign investors will now be buying large quantities of Kenyan schillings, Lebanese pounds, and Sri Lankan rupees.  Of course, when foreigners periodically sell, the currencies will swoon and those local markets will shudder.

I’m not suggesting that adventurous investors should avoid the frontier markets.  There’s nothing wrong with building a very diversified portfolio of frontier markets with a small portion of an investor’s capital.  However, the attractive characteristics described by Blackrock are going to be fundamentally changed when American and other investors from developed markets invest their capital in the new frontier.

The very same phenomena took place when American equity began investing in earnest in Europe and Japan, and again when we discovered Korea, Taiwan, and Eastern Europe.  The lesson is straightforward.  Observations about markets seldom account for the impact that investors have when they arrive en masse to exploit the apparent opportunity.


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