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Introduction

Over the years, we have been treated to new investment vehicles every century/decade or two. Since cave man days, there has been real estate. Banks brought us savings accounts, followed shortly by brokers selling bonds and stocks. We then heard that placing large bets on individual stocks was too risky so we invested in mutual funds. And when we got the news that most mutual funds underperformed their closest index, we bought ETFs. At least that is what happened in the US and most of the developed world. But how about emerging market countries? Will they follow the same path?

A very interesting study was done on this subject several years back by McKinsey & Co., and much of the data that follows comes from the report. The question is relevant inasmuch McKinsey estimates that emerging market countries already own 21% of global financial assets and projects that by 2020 they will own 36%. And if you add in real estate, they are already the world's largest asset holders. In what follows, I discuss several aspects of this continuing transformation and offer some hypotheses for the future.

Household Assets

Table 1 gives estimates of the relative importance of the different asset holdings of households. While real estate is the largest asset holding in both Germany and India, financial assets are more important in the US, as are its supporting services, both pension funds and insurance companies.

Real estate would be even less important in the US (14%) if mortgages were netted out. My sense is that real estate constitutes at least 50% of household assets in most emerging market countries. While financial markets are developing rapidly in China, many city dwellers even today purchase real estate for capital gains rather than equities.

Table 1. - Household Assets, 2010

Item

US

Germany

India

Real Estate

26%

40%

47%

Financial

38%

36%

28%

Pension/Insurance

20%

17%

9%

Other Physical

7%

6%

14%

Proprietors' Equity

9%

2%

2%

Total Assets (tril. US$)

70.4

12.1

3.2

Source: McKinsey & Co.

Financial Investors - Who Are They?

Table 2 indicates that today's investors differ significantly by country. Several things stand out:

  • Households in China control a much smaller share of financial assets than in the developed world. Governments, state enterprises and corporations control a lot more. This is also true for many other emerging market countries. State enterprises play a far more important role in these countries than in the West, e.g., 6 of the 10 largest oil companies are state-owned.
  • Sovereign wealth funds are large, with assets of $4.3 trillion. 37% of them are in the Middle East, 16% in China and 26% in other Asian countries.
  • The US is notable for the size of its "supporting" financial institutions - the pension and insurance companies.

Table 2. - Financial Investors by Country and Region, 2010

Western

Other

Latin

Total

Group

US

Europe

Japan

China

Asia

America

Other

Total

tril. US$

Households

46%

43%

42%

33%

44%

51%

41%

43%

85

Institutions

39%

28%

25%

6%

13%

15%

22%

27%

53

Pensions

26%

10%

12%

3%

5%

10%

14%

14%

28

Insurance

11%

18%

13%

3%

8%

4%

7%

12%

23

Other

2%

0%

0%

0%

0%

0%

1%

1%

2

Corporations

10%

25%

29%

39%

18%

18%

15%

21%

42

Banks

7%

22%

25%

20%

7%

13%

12%

15%

31

Non-Fincl.

3%

3%

4%

19%

10%

4%

3%

6%

11

Governments

4%

4%

4%

22%

26%

16%

22%

9%

19

Central banks

4%

3%

4%

13%

15%

7%

10%

6%

12

Sovereign Wealth

0%

1%

0%

4%

7%

1%

9%

2%

4

Other

0%

0%

0%

6%

3%

7%

2%

1%

2

TOTAL

100%

100%

100%

100%

100%

100%

100%

100%

198

Source: McKinsey & Co.

Investment Vehicles

So how does the world invest its financial assets? Table 3 provides the answers. And here again, there are several notable features:

  • Asian and Latin American households appear quite conservative by Western standards by holding their assets in cash or deposits. Of course, this in part reflects the absence of alternative investment vehicles.
  • The US has a far larger share of its financial assets in equities than any other part of the world.
  • Emerging market central banks have conservative holdings. Sovereign Wealth Funds, in contrast, have even more of their funds in equities than even the US. This in part reflects Western financial management practices.

Table 3. - Financial Asset Holdings by Selected Investors, 2010

Other

Emerging

Sovereign

Western

Emerging

Latin

Central

Wealth

Asset

US

Europe

China

Asia

America

Banks

Funds

Cash/Deposits

18%

39%

81%

77%

54%

10%

15%

Fixed Income

30%

23%

5%

13%

24%

90%

29%

Equities

47%

34%

14%

10%

14%

0%

52%

Other

5%

5%

0%

0%

0%

0%

6%

Total (tril. US$)

42.0

28.3

6.5

1.8

3.5

5.9

4.3

Source: McKinsey & Co.

Another McKinsey report provides a somewhat different view of capital and debt markets (Table 4). Here we see how a country's stock market capitalization compares to various loan and debt totals. Japan's public debt is quite striking. Its stock market has declined over the last 20 years so households have purchased low-yielding government debt. In China, there is very little public or private debt aside from the high volume of bank loans that have gone primarily to state enterprises. The US is notable for its high level of securitized loans. Yes. Those are the loans banks make without regard to risk and sell off for fees….

Table 4. - Capital and Debt, Selected Countries, Regions, 2010

Capital/

Western

Latin

Debt

US

Japan

Europe

China

America

Stock Mkt. Cap.

26%

16%

17%

35%

39%

Public Debt

16%

48%

18%

10%

26%

Private Bonds

32%

11%

34%

10%

16%

Securitized Loans

17%

2%

4%

1%

2%

Other Loans

10%

23%

28%

45%

18%

Source: McKinsey & Co.

Investment Vehicles Revisited - Equities, Mutual Funds and ETFs

Table 5 traces the evolution of investment vehicles. In 1995, stock brokers ruled the roost. By 1995, mutual funds had started their domination. The latest vehicle - ETFs - has grown rapidly in recent years. 2007 was the peak for equities and mutual funds globally and in the US. In the US, ETFs have continued to grow and cut into mutual fund dominance.

Table 5. - Equity, Mutual Fund and ETF Assets (bil. US$)

Vehicle

1995

2000

2005

2007

2011

Equities - US

4,166

7,317

5,592

9,632

8,721

Mutual Funds - US

2,811

6,965

8,891

12,001

11,622

ETFs - US

1

66

301

608

1,048

Mutual Funds - Global

na

na

17,757

26,131

23,780

Mutual Funds - Europe

na

na

6,002

8,935

7,220

Mutual Funds - Asia

na

na

1,939

3,678

2,921

Source: Investment Company Institute, Federal Reserve, Flow of Funds

Investment Implications

What if anything does all this tell us? One could see the US evolution from property to savings accounts to equities to mutual funds to ETFs happening in the developing world. Let's hope they learn something from Western banking fiascos with securitized loans and sovereign debt - don't let banks sell off the loans they make!

There is also the question of ETFs versus mutual funds. As I have suggested in an earlier piece, there are times to prefer one over the other.

Then there is the broader issue of what will happen to equity markets. In the first McKinsey piece cited, it is argued that by 2020, there will be an "equity gap" of $12.3 trillion where gap is defined as financing needs (mostly in emerging market countries) not covered by equity markets. One wonders. But it is clear that at least in the US, financial mechanisms labeled as "private equity" and "hedge funds" are buying up listed companies.

Right now, Western nations own 85% of all equities. Their purchases and sales pretty much determine what happens to equity prices in the developing world. And as I have noted, when financial panics occur, as they have with great frequency recently, Westerners sell their emerging market stocks off first. The result? Much wider swings in emerging markets than in Western stocks. Growing equity ownership in emerging markets should dampen the "betas" somewhat, but it will take time.

Source: Real Estate, Savings, Bonds, Stocks, Mutual Funds, ETFs: What Will Be The Next Investment?