Fund Managers magnifying glasses on Emerging Markets

Why is it that fund managers (‘Asset management companies’) look at companies and emerging markets with a magnifying glass? Isn’t it the same models and analytical techniques used when investing in developed markets?  Why do Asset Management companies always require a higher return from their investments in developing nations?

Although the fundamental behavior of participants in capital markets towards emerging and developed country’s is the same, fund managers tweak the models of analysis and investment strategy for emerging markets to incorporate the unique government and other institutional factors, that are specific to that emerging country. WHY?

Information Inequalities: one unique feature of emerging markets is the presence of significant information inequities between investors. (By Information inequities we mean different information is available to investors at different periods of time). The traditional developed markets view is that news is distributed widely and instantaneously so prices reflect all public information. However in the stocks of companies in developing markets, there is asymmetry of information available and very limited information available in public domain. This leads to an uneven playing field for taking investing decisions as insiders know considerably more than do outside investors and thus Asset management companies require a higher compensatory return.

Insider Trading Regulation: Any information that is very sensitive to the price of stock is called Material Information. Further if this Material Information is not yet available in public domain it is called “material non public information”. Let me illustrate this with the help of an example

If Mr. Arun is the head of finance of Reliance Industries Limited (‘RIL’) and has 5000 shares of RIL. Since he is an employee of the company he would obviously be having sensitive information such as EPS, profits and other sensitive information. If Mr. Arun trades (sells or buys RIL stock) on this information before the news of EPS and profits is distributed to the public it is called trading on material non public information and he can be prosecuted for this.

As we studies in all our cases, legislation and regulation are not easily enforceable in developing nations as in developed markets and that’s why Asset Management companies demand a higher rate of return and premiums on their investments made in these countries.

Financial Disclosure: Another reason, for demanding higher returns by Asset Management Companies is lack of transparency of earnings resulting from poor accounting standards, biased accounting view of Independent Accountants and perverse management motivations. As majority of the analysis done by Asset management companies is by using Annual Reports, regulatory filings and other relevant information. The lack of financial disclosure within these documents mentioned above and the added perceive risk by these Asset Management Companies require them to earn a higher rate of return in these emerging markets. 

Market Illiquidity and High transaction cost: As stock markets are not well developed and integrated into the global financial system there is the presence of abnormal illiquidity and other form of transaction costs that asset management company’s factor in their increasing demand of return. There are few countries which further discriminate on transaction cost between domestic and foreign investors – thereby requiring the Foreign Asset managers to further increase their expected rate of return from the developing markets.

However majority of the Assets Management companies have invested in emerging markets recently and have made exponential return on their investments.

Further this is not an exhaustive list of the reasons why Asset management companies require higher returns – but just a small snapshot will be back soon with a working model. 

Cheers!

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written by Tarun Ajwani (tarun.pgdm14c@greatlakes.edu.in)