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Colin McLean: beating the cognitive biases of EM investment

Colin McLean: beating the cognitive biases of EM investment

No matter how hard investors try to analyse prospects clinically, emotion is never far away.

Particularly strong feelings are attached to bold investment concepts, such as emerging markets. The idea of growth is exciting, and the thought of big rewards for riding a rollercoaster seems only fair.

It is all too easy to see the issues as abstract concepts like the future, patience and reward. Unfortunately, in the battle between rational analysis and belief, facts by themselves rarely change decisions. It will take real fear to drive the emerging market fans to recognise some ugly truths. 

For more than 17 weeks, emerging markets have seen net outflows, but to date this has been a steady flow rather than a panic.

The tone of reports from emerging market fund managers is typically soothing and reassuring. Language
such as ‘structural growth’ and ‘hiccup’ tries to put current problems in a historical context.

But will managers and their clients remain as sanguine if conflict spreads, borders change, or capital controls become the norm?

Investors might start reaching for 60-year old atlases to understand how nations, alliances and currencies might change. The risks have moved from the eurozone break-up to changing borders in emerging Europe or a possible China/Japan conflict.

The path of economic development is rarely smooth, and analysts often struggle to see the political fallout from the inevitable setbacks.

Investors’ main tool is financial analysis, but this rarely helps much with interpreting political turmoil. It is easy to see problems as mainly economic; politics simply does not fit on spreadsheets.

Inconsistency

Investment banks tend to update company forecasts as results come out but only revise top-down issues, such as currencies, on a quarterly basis. Much of the time the two approaches are inconsistent. Political issues are interpreted in the financial perspective that analysts know best. Emerging market problems have been reduced to calculations of US Federal Reserve tapering, blinding many to the deeper problems. 

When information is presented in the wrong frame – in this case, as economic not political – objective analysis is a challenge. Indeed, in many countries, economic policy itself is driving politics, creating division and a democratic deficit.

In the West this has been via money printing; in emerging markets, through capital inflows and bubbles. What looked like an economic fix has created disruption and unemployment.

Moving back onto a sustainable growth path in emerging economies cannot simply be fixed via their central banks. And contagion across borders is not only through financial links, but driven by philosophies and events. Stability will only emerge when both economic and political issues are addressed.

Little investment commentary to date addresses the possibility of upheaval. Presentations seem designed merely to comfort clients, and it may be the incentives that are unhelpful in offering a realistic assessment of emerging market problems.

Fund managers who are already deeply committed to emerging markets, are challenged by fees that act against a balanced reappraisal of new risks.

Emerging markets funds typically have premium charging structures, with even higher fees for investors where a ‘soft close’ is in place. Funds with this type of close can see net outflows, while maintaining the fiction that it will be hard or expensive for investors to return if they sell now. 

Some of the market statistics point to the gains that investors have seen in emerging markets, but also what a poor signal this has been.

Ukraine was the best performing global market in the first decade of this century with a 900% gain. China more than doubled in the same time, and just 12 months ago Russia and Turkey were strong performing emerging markets.

Now the rouble is making all-time lows, with investors selling Russian rouble bonds, and Turkey has a huge need for external finance.

Some of the investor biases are deep rooted in human behaviour. It is hard to accept the fact that economic growth has only a low correlation with stock market returns. Change that occurs only once or twice in a lifetime is hard to learn from and use in decisions.

Emerging markets look set to test investors’ nerves this year; investors must understand their biases if they are not to sell when fear eventually strikes.

Colin McLean is director of SVM Asset Management and runs its UK Growth fund, returning 58.15% over three years versus a UK All Companies average of 38.6%.

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