Why Are Emerging Market Prices So Volatile?

Consider this. All emerging markets combined account for 4.4% of world equity market capitalization. The developed country markets account for 95.6% of world equity market capitalization (S&P/Citicorp Global Equity Indices). If developed country investors decided to allocate an additional 1% of their equity assets to emerging markets, that would add nearly 22% to the market capitalization of the aggregate of emerging markets.

Let's say those emerging market have an organic growth in market-cap of 8% due to growth in their economies and profits. The combination of 8% earnings-based organic growth and 22% flow-of-funds-based market cap growth (probably in the form of P/E multiple expansion), could create something like a 30% increase in market-cap for the emerging markets.

The same happens in reverse. If the developed country investors decide to reduce their portfolio allocations to emerging markets by 1%, they would be selling to create a funds outflow of little less than 20% of the market-cap of the emerging markets. If those markets had an organic market-cap growth of 8% and a negative flow-of-funds driven growth, the overall effect on those emerging markets could be something like a 12% decrease in market-cap.

An analogy between the flow of funds and the flow of water may be helpful. If you have ever watched water flowing from a large stream to a narrow stream, you will have noticed that it speeds up in the narrow channel and then slows down again when it exits the narrow channel back into a wider stream. Something similar happens with markets. The developed countries are like the wide water channel and the emerging markets are like the narrow water channel. When minor allocation changes in developed markets (like slow moving water in a wide channel) enters or exits an emerging market (like the fast moving water narrow channel) the rate of change of values in the emerging market has to accelerate up or down depending on the direction of flow of money.

Now let's assume that a particular country - say China (FXI) - becomes a darling and the bulk of the reallocation from the developed markets goes to that one country. Well, then things really get hot. Since the door swings both ways, the very fast changes in market cap can be positive or negative and can change as quickly as a flock of birds can change direction following their leader in flight.

China, for all its general economic power ,represents only 2/10th of 1% of the world's free-float (investable) equity market-cap. If developed country investors reallocated 2/10th of 1% of their equity portfolio, then China's markets would double in size, even before organic growth. Something like that happened in 2006. Be wary, though, of the reverse. It would only take the slightest re-evaluation by developed country investors to shift their allocation and reverse the tide in a dramatic way.

Comments

[ikkyu:]

That was an extremely helpful explanation.
Thanks!
john

2007 Jan 30 08:11 AM

[Dave Malhotra:]

I am not convinced your argument--yet. To use China as an example, I looked up the total asset value of FXI. As of 1/30/07 it was USD 5.486 Billion. (from www.ishares.com/fund_i...;symbol=FXI). This doesn't seem like enough to cause much volatility in the underlying shares when you consider that one of its twenty-five underlying components, China Mobile, alone has a market cap of HKD 1.5 Trillion (which converts to USD 192 Billion). I don't know what the aggregate market cap of all the FXI components is together, but it is surely huge relative to FXI's asset value.

However I am wary of my own analysis because I know its misleading to use market cap because of the large amount of non-tradeable shares. Non-tradeable shares lead to inflated market caps, so using market cap in my comparision is misleading to the degree that the market caps are inflated. Also I know there are many other ETFs, Closed-end funds and ADRs besides FXI that foreigners can buy that would result in the flow-of-funds into the Hong Kong and mainland exchanges. One would need to total all of these sources of foreign/developed world money and compare it to the domestic Chinese/HK money invested. Things are further complicated by the fact that there are difference classes of shares which would each have different levels of foreign and domestic investment.

I guess what it really boils down to is this: Is there data on the developed countries' flow-of-funds to the emerging market so we can compare them to domestic funds? I'm particularly interested in a breakdown of foreign funds going into Chinese A shares, B shares, H shares and red chips...

dave

2007 Feb 01 03:05 AM

[QVM Group:]

Dave, I do not have money flow figures from developed countries to emerging markets, but I do have figures for money flows within the U.S. mutual funds industry (vastly larger than the ETF industry) into and out of domestic and non-domestic funds. It is wholly applicable data, but it may be generally indicative.

Form 2002-2006 55% if net inflows to equity mutual funds was to non-domestic and only 45% to domestic funds. In 2006 the net inflows to non-domestic funds was 6 times as great as net inflows to domestic funds. In December 2006 the net inflows to non-domestic funds was over $13 billion while the net flow to domestic fund was negative $2.5 billion.

You can see an accelerating pattern of shift from domestic to non-domestic.

2007 Feb 01 09:42 AM