An investment taxonomy that actually makes senseBy John Authers, Financial Times | May 03, 2017
Defining "emerging markets" is an important and expensive business. Any who doubts this should note the annual hoop-la over how MSCI, the most widely used indexer of emerging markets, chooses to re-classify which countries fit in which category. It is now a major market event every June.
MSCI's definitions have to do with markets themselves, with institutions, and with investors' access to them. Economic development matters but is less important — as can be seen by MSCI's continued classification of South Korea as an "emerging" market.
Another aspect is corporate governance. Markets where minority investors lack protections are, correctly, deemed less developed. But corporate governance comes in far more than two varieties, and it tends to overlap with broader political governance.
Fascinating new research by JP Smith at EcStrat consultancy has produced a new taxonomy which divides investment markets into nine different governance regimes. They make a very useful guide to investing. In order, they are:
- Liberal — a grouping that includes almost exclusively anglophone countries, from the US and the UK through Australasia to South Africa. They have transparent markets, with high levels of free float and a high ratio of market cap to GDP, and a separation of ownership and control, which tends to be widely spread. They have a domestic base of investment institutions, which prioritise returns over other objectives, giving rise to what Hyman Minsky termed "money market capitalism".
- Co-ordinated — a grouping almost exclusively drawn from the EU. They differ from liberal countries in having a lower ratio of market cap to GDP, with banks providing more capital than equity markets, and control residing with large blocks of shareholders.
- Network — Japan and Taiwan are the only examples: they are similar to co-ordinated economies, but companies tend to gain most finance from other companies or banks within their networks, which are defined either by supply relationships, or by families.
- Hierarchical — a group that includes much of Latin America, and southern and Southeast Asia but also European countries such as Italy, Spain and Portugal. Control tends to be exerted by a few dominant families. They have relatively low free float, and controlling families in practice have relatively few checks on their action. As they are based in politically hierarchical societies, significant changes in governance tend to require a political crisis.
- State-guided — a group that ranges from Singapore through Malaysia and the UAE to Pakistan. The government itself tends to take a direct role in allocating capital and in corporate decisions, while equity markets tend to be small and hard for foreign investors to access.
- Authoritarian — China, Russia, Saudi Arabia and a few others. State-controlled companies dominate, in economies that are often based around commodities. There is some transparency but it is low, and there is "rent-seeking" by politicians and corporate executives alike.
- Dependent — a category that includes the Czech Republic, Hungary, Kenya and Argentina; these are countries with relatively small markets, that tend to be dominated by foreign owners. The problem, in the event of a crisis, is that the foreign owners become obvious targets for politicians.
- Autarkic — EcStrat lists Venezuela, Cuba, Iran and North Korea; this sounds more like George W Bush's "Axis of Evil" that does little to appeal to foreign investors.
- Disrupted — disaster zones such as Syria and Libya, while EcStrat controversially adds Nigeria.
Most will recognise that this list makes a deal of sense, and many of the countries grouped together naturally belong to each other in the minds of many investors. Countries can move between different regimes over time, and indeed there is a natural progression, along with the possibility of regression.
Mr Smith demonstrates that global investment trends since the end of the Cold War can be explained easily using his taxonomy. From 1991 to 2002, liberal models were in the ascendant, with the wave of emerging markets crises that started in 1997 speeding the trend; this was the era of the "End of History", as eastern Europe tried to set up liberal regimes, while multilateral organisations pushed crisis-hit Asian nations to move in that direction.
From 2003 to 2010 we witnessed the crisis of liberal capitalism, and the rise of state capitalism. Russia, China and Brazil appeared to have the answers as investors looked to the "Brics" while hierarchical countries tended to move in an authoritarian direction.
Since then, as far as markets are concerned, we have witnessed the decline of authoritarian models, and the slow rehabilitation of the liberal model — although of course electorates appear to disagree strongly. The critical question of the moment, for voters and investors alike, is: which model will now triumph?
(In earlier stages, the network economies and the co-ordinated economies both also had long periods of appearing to have the answer compared with the liberal Anglo-Saxon model; while even countries as Anglo-Saxon as the UK did not always fit the "liberal" model as defined by EcStrat).
The key is that any model needs to reach a stage of hubris before it turns downward, and go through a crisis before it begins to regain the ascendant.
By now it should be clear that the taxonomy has many promises. It combines a practical bottom-up approach with a useful method for gauging long-running macro trends. Its sub-divisions are more useful than a sweeping division of the world into developed, emerging and "frontier". And it should not be difficult for indexers to produce indices to cover the categories.
With passive investing increasingly displacing attempts at stockpicking, asset allocation grows ever more important. This schema is very promising, and could well allow asset allocators to move their capital far more effectively.
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