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 Introduction
When
investors refer to risk in their investment portfolios, they are typically
referring to volatility, as measured by the standard deviation of returns
on a daily or monthly basis. Introduced by Harry Markowitz in his now famous
and Nobel-Prize winning paper "Portfolio Selection", it is
a convention that conveniently puts a number on the level of risk inherent
in owning a security or portfolio without having to do a lot of analysis
or even calculation.
While this convention brilliant in its simplicity and very useful, a thorough
analysis of risk requires much more careful consideration. This is especially
true in the emerging markets that do not have the added benefit of market
history, stable government and the rule of law. The purpose of this paper
is to broaden the discussion of risk, apply it to the emerging markets
and discuss how investors ought to handle those risks.
Risk
'Risk' is a broad term. It has many meanings and it is crucial
for an investor to understand which types of risk need to be minimized
and the types with which they are comfortable. Very often, this means that
the investor must make tradeoffs. For example, just by choosing to invest
in the markets rather than putting savings into cash, an investor is opting
to assume market-related risks and reduce shortfall risk (the risk of not
meeting savings goals.)
While building a portfolio an investor may ask:
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Will this portfolio generate sufficient income to support my
lifestyle?
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Will the portfolio's movements in value be so great that I lose sleep
while worrying?
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Will I outlive my savings in retirement?
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What if I own the stocks or bonds of a company that goes bankrupt or defaults
on its debt?
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What if I own the stocks or bonds of a company that is nationalized?
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How will my portfolio be impacted if the value of currency changes?
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How will my portfolio be impacted if there is a war or a government collapses?
Clearly some of these questions -- the second, for instance -- can
be addressed very well by the standard deviation definition of risk. For
others, this is not the case. The last four questions in particular can
be very tricky to answer and rely to a large degree on the nature and location
of the event. A bankruptcy or default in Russia or China would probably
be more detrimental to a portfolio than a bankruptcy in the US, if only
because the US has a set of rules and standards and there are laws to guide
shareholders through such a process. On the other hand, if the US defaulted
on its debt, it would have far more disastrous effects than if a smaller,
less stable government did the same.
These sorts of risk are not necessarily reflected in the price changes
of the securities. Taking them into account in a portfolio requires a disciplined,
diligent approach and the lessons of experience.
Two interesting real-life scenarios to demonstrate this idea are the collapses
of two companies; Northern Rock, a bank in the developed UK market and
Yukos, an oil company in the emerging Russian market.
Case Study: Northern Rock Bank
In the graph below, you can see that for
the first three to four months of 2007, investors seemed to be pricing
Northern Rock in line with other
European banks. In early April of that year, American subprime lender New
Century Financial filed for bankruptcy and investors began to price the
Northern Rock with some probability that the company's mortgage exposure
would hurt the company. At this time, the company was still highly profitable
and the UK's market-leading mortgage provider.
As investors learned more about the extent of the problem with subprime
debt and Northern Rock's exposure, the situation developed where
the company was priced as though bankruptcy was a distinct possibility.
Through the summer of 2007, the stock looked very inexpensive compared
to its peers and was clearly mispriced -- if it was to go bankrupt
then it was overpriced and if it was to survive then it was underpriced.
The volatility of the stock at that time was less than twice that of the
index and certainly would not have indicated the possibility of a massive
80% loss that was to come in September.
Between September 12th and 14th of 2007, it was revealed that the Bank
of England had given emergency assistance to Northern Rock, which said
that the funds would keep the company stable and solvent throughout the
emerging crisis. Panic set in and depositors lined up to withdraw money,
further hurting the bank. The price in October seemed to reflect that the
most likely outcome was bankruptcy or nationalization. In fact, the company
was nationalized in February 2008.
For the truly risk-aware investor, the risks were apparent long before
Northern Rock's stock price lost so much of its value while the fundamental
investor looking only at the numbers and the company balance sheet may
well have believed that the company was far more secure and would eventually
rebound. While there is no guarantee that the risk-aware investors made
more money (or lost less money) than anyone else, it seems that being aware
of the risks should have at least provided them opportunity to sell before
those who were less cognizant of the real risks involved.
Case Study: Yukos Oil Company
Of course, the story of Northern Rock occurred
in the United Kingdom, which has the added benefits of a mature government,
well-established markets
and the rule of law. Russian oil conglomerate Yukos failed in a much more
complex environment where the risks are greater and less foreseeable.
Yukos was one of the world's largest oil companies in the late 1990s
and early 2000s and the largest private oil company in Russia. Until 2003,
the company's shares traded more or less in line with the broad Russian
index. The company was massively profitable following the restructuring
of the late 1990s and oil prices had begun to rise, further helping profits.
This was more or less the extent of what an outside investor knew about
the company. The risk of the company bankrupting was seemingly very small
in the eyes of the shareholders.
Even after the government inserted itself into the situation in late 2003
and declared the company to owe billions in back taxes, it was entirely
unclear what path the company would take to resolve the situation. It was
widely believed that they would continue to be profitable regardless of
the outcome. After a severe hit to the stock price at the end of 2003,
it again traded more or less in line with other Russian companies while
the situation played itself out.
In the spring of 2004, arrest warrants were issued for a number of senior
associates of the company and the stock again began to slide lower. No
one knew what the fate of the company would be or whether it would or could
declare bankruptcy. Even if they did, it was questionable where would it
do so or whether it would be protected from the tax payments they owed
the government.
In fact, the company attempted to declare bankruptcy in the United States
as an international entity but the Russian government did not recognize
it. The downward trend in stock prices continued until the company was
purchased by a small company called Baikalfinansgroup which was then bought
by state-owned Rosneft and the company was essentially nationalized.
Even after the fact, there remains debate about whether the government
had planned for this outcome, whether the company had avoided taxes legally
or illegally and whether the amounts owed in back taxes make any sense.
In any event, the risks of owning a company like this are very different
from the risks of owning a similar company located elsewhere. Transparency
in the markets and in government activities certainly would have allowed
investors to better understand the situation at Yukos, as would a court
system that is seen as unbiased.
For this reason, many risk-aware investors treat Russian companies very
differently than companies elsewhere. In some cases, it may be that they
monitor the political situation very closely or rely on local analysts
for information but there are others who refuse to buy Russian companies
or do so only in very small increments.
Overall, when looking for managers who invest the developing markets,
we want people who have very comprehensive views on risk and tend to have
a lot of controls -- both explicit and implicit -- on the risk
they allow into their portfolios. These can include such measures as visiting
the country personally, talking to people in the local governments and
industries, sizing positions appropriately, diversifying among companies
and industries and having a lower threshold to sell when headwinds present
themselves.
Conclusions
The innovation of using price volatility as a measure of risk
is incredibly useful and worthwhile but is by no means a comprehensive
solution. This
is particularly true in those markets with less transparency.
The solution that we prefer is twofold. First, investors should maintain
diversified portfolios. The intangible risks of each sector, market and
asset class are different. By spreading assets among various areas of the
market, an investor can necessarily limit broad exposure to any one intangible
risk.
The second tool to limit these risks is the use of mutual funds run by
knowledgeable, risk-aware managers. In all markets but particularly in
the developing world, the research required to understand the risks of
an investment portfolio require more time, discipline and experience than
most people have or are willing to commit. An appropriately-run mutual
fund should maximize return potential in any given market while being cognizant
of the risks involved.
Most importantly, risk takes many forms and can never be completely removed
from the life of an investor. The best option an investor has is to be
aware of the potential threats to his portfolio in order to lower the likelihood
that those threats become real losses.
-- Ben King, Senior Research Analyst
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