Why Emerging Markets Can Be So Volatile

We are sometimes asked why emerging markets are so much more volatile than developed markets.  The answer is that, due to their relative size, money flows between them cause most of the volatility effect.

Consider a real world situation that most of us have seen — a stream emptying in to a pond and another stream at the the other end of the pond draining the overflow.

Think of the streams as the emerging markets and the pond as the developed markets. Think of the water as money.

The water in the stream feeding the pond moves quickly.  When the water enters the pond, it slows as it spreads out in the breadth and depth of the pond.  When the water enters the stream draining the pond overflow, it moves quickly again.

The streams are narrow and shallow by comparison to the pond, which is broad and deep.  Any fixed amount of water moving through the streams must move more quickly than the same amount of water moving through the pond between the two streams.

Today, the developed markets free-float (represented collectively by Vanguard Total Stock Market VIPERs (VTI), iShares MSCI Canada Index (EWC) and iShares MSCI EAFE Index (EFA)) is about nine times the size of the emerging markets free-float (represented by Vanguard Emerging Markets Stock VIPERs (VWO)). Within the total equity allocation of all investors, an increase or decrease in the developed markets allocation will show up as a magnified opposite change in the emerging markets allocation.

If investors decreased their current 89% developed markets allocation to an 88% allocation (a minimal change), the emerging markets would change from 11% to 12% (a substantial change).  The inverse changes are similarly minimal for developed markets and substantial for emerging markets.

The comparatively minimal nature of the developed markets changes create only minimal supply-demand pressure between money and shares, whereas the comparatively substantial nature of the corresponding emerging market changes create substantial supply-demand pressure between money and shares.

The greater the supply-demand pressure, the greater the degree of price change.

Considering the current 9:1 developed-to-emerging markets ratio, if the current bear market causes collective investors to become more risk averse and to significantly reduce their emerging markets exposure in favor of developed markets, the emerging markets would be crushed.

Comments

[puttster]

Why do you say the size of the emerging markets free-float can be "represented"... by VWO? Do some research, please!

[Richard Shaw]

puttster:

Perhaps you should do some research please before offering hostile comments.

VWO is the Vanguard emerging markets ETF. It follows the MSCI emerging markets index which is a free-float index. Here is the text about the investment strategy from the Vanguard site:

Vanguard Emerging Markets ETF is an exchange-traded share class of Vanguard® Emerging Markets Stock Index Fund, which employs a “passive management”—or indexing—investment approach by investing substantially all (normally about 95%), of its assets in the common stocks included in the MSCI® Emerging Markets Index. The MSCI Emerging Markets Index is made up of common stocks of companies located in emerging markets around the world.

[puttster]

How can you "conclude" that the emerging market float is 1/9th of the world float by examining VWO? It's like saying the beach is 500 yards long by examining a grain of sand.

[Richard Shaw]

puttser:

We did not examine VWO to determine world market cap percentage. We used the S&P/Citigroup Global Indices to report that number and note that there are certain emerging market funds such as VWO (and EEM) that track an emerging market index and are therefore investable proxies for the emerging markets as a whole

Read the prior posting by Seeking Alpha at:
seekingalpha.com/artic...

[puttster]

Okay I agree.

[Indexor]

Wow! What a three-putt

[puttster]

Yes, but the green was in bad shape.