The Transformation of Emerging Markets

Three different sources of information came out earlier this month all centered around rethinking one asset class in particular: emerging markets. 

The first was an article written by Mohamed El-Erian, formerly of PIMCO, entitled “Rethinking Emerging Markets.” His article started by identifying three elements that typically define an asset class - 

First, its components share similar characteristics: geographic location, for example, or much more importantly for investment purposes, economic and financial commonalities. These similarities allow the investments to be modeled relatively coherently for expected return, volatility and correlations with other asset classes. Yet these assets aren't so completely homogeneous that they can be replicated via a single instrument, which also opens the possibility of out-performance thanks to active management.

Second, the majority of the components of the asset class are sensitive to an external influence that is strong enough and sufficiently encompassing to have a similar impact across the board. This can take the form of a single variable, such as the price of oil for producers, or it can be linked to a policy, such as the effect of the European Central Bank's quantitative easing on sovereign bonds.

Third, the actions of investors impose a self-reinforcing consistency in the way individual elements of the asset class relate to one another. This could be the case, for example, when the bulk of investors use a predominantly top-down approach -- which takes into account the asset class as a whole rather than its individual components -- or when markets are overwhelmed by large tides of capital, be they inflows or outflows.

El-Erian went on to suggest that the first two characteristics were no longer true. That is, emerging markets have changed so greatly they no longer have enough commonalities and are no longer affected by external actions across the board. His conclusion was that one should rethink asset allocation decisions and benchmarking to accommodate for the change in emerging markets as an asset class.

The second article, written by Ben Carlson, reviewed and expanded upon El-Erian’s discussion. Carlson offered up his own criteria for an asset class and then used that framework to analyze emerging markets himself. Carlson writes “Most professional investors benchmark their foreign stock allocation to the MSCI EAFE and then break down their funds or stocks further by region or country. But from an overall asset class perspective, this is still the benchmark the majority of investors choose to follow. I don’t see this changing anytime soon.” He follows this up by saying “A broad, diversified approach is still probably the best option for the majority of investors that don’t have the skillset or expertise to be able to analyze the different emerging market countries.” 

In other words, while Carlson acknowledges some changes in emerging markets as an asset class, he doesn’t see any significant changes in the way the investment management industry operates anytime soon.

The final source of information discussing the changes in emerging markets was the April issue of The Bank Credit Analyst publication. Their analysis indicated that there are large differences between emerging market countries on a GDP per capita basis; however, those countries still tend to have correlations close to one, particularly when a bear market occurs.

Stepping back for a second, I think that multiple sources discussing emerging markets as an asset class is informative in itself. The global economy is changing and will continue to change. It would be a mistake to assume that the current circumstances will carry forward indefinitely. The BCA issue noted that emerging markets are now more than 50% of global GDP on a purchasing power parity basis, as illustrated in chart 1: 

Chart 1, Shares of GDP

The Charles Darwin quote “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change” is one of my favorites, both personally and professionally. As a young financial planner, it is important to be open to new ways of thinking because the industry will change. Financial professionals cannot assume the current landscape will always remain as is. As discussed in this blog before, financial planning and investing consists of making assumptions. These assumptions will change, and asset class assumptions are one of them. As countries rise and fall, the general categories of developed and emerging markets will change too. For example, the United States was considered an emerging market not that long ago; however, this is nearly inconceivable now. Point being, a young financial planner will likely be a professional for another 40 years. Think back to 1975 - how has investing and the geopolitical landscape in general changed since then? (see chart 2 below) Keep in mind it will continue to change. How will the state of affairs look in 2055? I would venture emerging markets will be very different to say the least. 

Chart 2, Developed and Emerging Market GDPs, 1950-2050

Sources:

http://www.bloombergview.com/articles/2015-04-03/el-erian-rethinking-the-emerging-markets-asset-class
http://awealthofcommonsense.com/are-emerging-markets-still-an-asset-class/
BCA Research
https://blog.wealthfront.com/emerging-markets/BCA Research

Predicting Black Swans

It is always amusing to see articles and television spots predicting black swan events; they are by definition unpredictable. To try to see them coming is pointless. In the financial world, the big event on the horizon is the Federal Reserve raising interest rates, and there has been much debate about when (if?) this will occur. This is an important issue; however, I would guess what the Fed does will not be the big event of the decade. Rather, the most significant event will be something no one will see coming - a true black swan.
 
Morgan Housel has a great article entitled “You Would Have Never Believed It” where he writes examples of the unpredictability of the future. A few excerpts:

“You would have never believed it if, in 2004, someone told you a website run by a 19-year-old college dropout on which you look at pictures of your friends would be worth nearly a quarter-trillion dollars in less than a decade. (Nice job, Facebook.)”

“You would never have believed it if, in 1900, as your horse and buggy got stuck in the mud, someone pointed to the moon and said, ‘We'll be walking on that during our lifetime.’”

“You would have never believed it if, three years ago, someone told you that Uber, an app connecting you with a stranger in a Honda Civic, would be worth almost as much as General Motors.”

“You would have never believed it if, after the lessons of World War I, someone told you there'd be an even bigger war 25 years later.” 

Housel concludes the article with this:
“But all of that stuff happened. And they were some of the most important stories of the last 100 years. The next 100 years will be the same.”

Research has shown that we tend to overestimate changes in the short-term and underestimate changes in the long-term. To try to forecast or predict bubbles, black swan events, and major world events is useless. To change your investment strategy in response to these predictions is even more foolish. 

Josh Brown notes the following regarding this:
“[Mark] Hulbert had made the point that no one will see the thing coming that derails the economy or the market next time around. It certainly won’t be something that’s on the front page of the newspaper each day like Greece or interest rates. I would add in that we still cannot pinpoint the events that have marked previous market tops even in hindsight.”

While it is important to monitor the economy and geopolitical environment, trying to predict the unpredictable is a losing effort. Financial planning consists of making assumptions: assumptions about rates of return, assumptions about health, assumptions about legislation, assumptions about inflation, assumptions about family, etc. Chances are these assumptions will not be spot on. Despite this, all plans, financial and otherwise, rely on assumptions. This is why it is important to have an emergency fund, power of attorney, and insurance in case your assumptions aren’t as accurate as you would have hoped.

Robo-advisors and the Fed raising interest rates are two examples of developments with consequences still to be determined. Many are predicting they will have a large impact on the investment and financial planning landscape, which they probably will. That being said, as Justin Frankel wrote two weeks ago, “Don’t let the noise about Fed moves disrupt an otherwise well thought out investment process.” He continues: “The anticipation and subsequent parsing of Janet Yellen’s testimony and other assorted speeches from Fed officials last month was (rightly or wrongly) often cited as the cause for market moves, but in reality any Fed-related anxiety has likely been overplayed by the media.”

While both the Fed raising rates and the emergence of robo-advisors may or may not be disruptive, they are not black swan events. It is far more likely some unforeseen event has a greater impact on the investment and financial planning industry. Point being, quasi-black swans can be important but will likely not be as significant as the true black swan events that no one sees coming.

Financial Fitness: Personal Finance > Investments

The easiest guy to mock at the gym is the one with huge biceps, a large neck and tiny legs. We all know that guy; the guy who inspired the dire warning to not skip leg day. In terms of my personal fitness goals, this is my nightmare.

I consider myself to be a comprehensive financial planner, but some of my friends think I am that guy. Many of them see me as the “stock market guy” and are always ready to chirp at me with their latest stock picks or recent “naked call option” strategies. Sure, investing in stock and bond markets is a large part of what I do and I enjoy doing it, but as someone who is focused on being a well-rounded financial planner, I want to be sure that the people I help are happy in all aspects of their lives; not just their portfolio’s returns from last year.

Making Six-Figures and Going Broke

So how do we keep clients happy and financially fit? I’m fortunate enough to be at a firm that does business in a couple of ways. The majority of the business takes a traditional route where we manage assets and give financial advice for an annual fee. But our other business avenue allows for a much wider client base; hourly financial planning. Under this model, we charge for financial advice at an hourly rate; similar to a lawyer’s billable hours. This is where I’ve learned the most about people and their attitudes about their money.

For example, in the San Francisco Bay Area, it is not uncommon for a dual-income family to have pre-tax income of over $300,000. Where I’m from in Texas, this would be considered an above average income and would provide extra breathing room for a budget. But in this high cost-of-living area it is very common for that same family to be cash flow negative AKA “broke” at the end of month.

While not everyone shares the same money attitudes, a surprising number of people will blame their inability to save for their own future on their below-average investment returns. In reality, the real issue is self-discipline in their personal spending and savings habits. The point of frustration seems to (irrationally) be on their advisor’s lousy investment performance.

Again, investment planning is definitely in my job description, and I’m glad to give advice on anything that will help my clients make more money. However, if you make $300,000 a year and do not have any money at the end of the month, there might be larger issues to address besides stock performance. Money management would be all too simple if the solution was always to change advisors instead of change behaviors.

Being Financially Fit

Investments-only financial planning is the equivalent of walking into the gym, doing some heavy bicep curls, chugging a protein shake and telling people “yeah, I work out.”

Getting in-shape takes a lot of effort – cardio, weight lifting, a healthy diet, motivation, and much more. If you’d like to work out more but are lacking the education to be truly fit, perhaps it’s time to hire a personal trainer to get you in shape and coach you along the way.

When it comes to your money, a comprehensive financial planner is similar to a personal trainer – we help you shape up your financial life. A true financial planner should give you much more than a good investment portfolio. Your advisor should talk to you about the whole picture; from cash flow and savings patterns to college expenses for your kids and your relationship with family members. I even like to know how my client’s feel about their work-life balance.

Work for It

If you have $200,000 and hire me to make you a millionaire via record-setting investment returns, I’m sorry, but I can’t reasonably promise you that outcome and you will likely fire me. However, if we begin our relationship with $200,000 and you are willing to let me coach you until you’ve reached your ultimate goal, I’m happy to take that journey with you as your advisor and coach.

Time to hit the gym now; its leg day.