new perspectives on investing in Emerging Market

Global Capital Market – Lecture 1W Capital Market Theories Emerging Market Finance CAU MBA CAU Wonil Lee, Ph.D, & CFA New Perspectives on Investing in EM April, 2015 What makes investing in EM unique?  Should diversification always reduce portfolio risk?  Should the principles of investing in the US or the UK apply to EM?  Should EM investing always demand higher expected returns?  Although the fundamental behavior of participants in capital markets is the same, EM contain unique governmental and other institutional features that create distinct differences in the way investors must approach their investment strategies. Emerging Market Overview 3 * Source : MSCI Capital Market Theories 1863, NYSE 1959 , Markovitz Model 1964, CAPM 1974, ERISA 1997, Asian Currency Crisis 2002, Nasdaq Bubble 1987, Black Monday 1962, DDM 1973, Black & Scholes Model 2007, US Sub Prime Non normality in Returns  It is generally accepted that EM stock returns are not normally distributed.  Extreme returns are more frequent than under a normal distribution, which results in a fat-tailed distribution  These return distribution violate the normality assumption in the mean- variance analysis framework commonly used in portfolio theory  Positively or negatively skewed returns are a result of company ownership, corporate governance, and opaqueness. This also contribute to synchronicity of stock market returns  And this is why financial theories are seriously not working in EM The Market Synchronicity Puzzle  Traditional portfolio theory suggests that the risk of a security can be divided into 2 components: market risk and company specific risk.  One measure of the importance of market risk is the percentage of stocks in the market that move together over a particular period.  A market in which all stocks move in the same direction is said to maintain high market synchronicity. Academic researches have found that EM markets tends to have much higher market synchronicity than developed markets.  In the US, the market synchronicity is around 57% while in Malaysia, China, Poland, and Korea record 75%, 80%, 83%, and 70%, respectively. Information Inequities (Asymmetry)  Significant information inequities in EM among investors  Many of the institutional mechanisms for information dissemination in developed markets are commonly missing in EM as individual investors are majority of the EM  Efficient market hypothesis are generally weaker in EM  Outside investors receive only market wide news which results in higher synchronicity of the market – usually big information asymmetry in EM between insiders and outsiders  This information asymmetry create an uneven playing fields that fundamentally affects investing decisions. Insider Trading Regulations  Unlike developed markets, EM stock price is not changing in accordance with the information. In other words, semi-strong form Efficient Market Hypothesis cannot be proved  In many EM, trading based on material non-public information seems to be easier than developed market and information dissemination by analysts are not transparent and efficient  Last year, CJ E&M case was one of the example that Korean market is still considered as EM  Empirical findings support the notion that unprosecuted insider trading makes the information in equities even worse Any Information Advantage?  There are mixed literature conclusion about information advantage of domestic vs foreign investors  Some research argue domestic investors have information advantage over foreign because of geographic location and home advantage while some other research conclude that foreign investors (from developed market) tend to have better information about broader market timing and sector selection thanks to investment know-hows.  Current academic thinking is that geographic location is particularly important in that local investors in EM naturally have an information advantage over foreigners.  Another reason for information inequities is lack of transparency of earnings disclosure resulting from poor accounting standards, lack of credible auditing, and bad corporate governance practices in EM  Many Korean investors are using foreign local managers when they invest overseas market Market illiquidity  Another explanation for the synchronicity effect in EM is the presence of abnormal illiquidity and other forms of transaction costs  Empirical research confirm that EM securities are commonly more illiquid even if each EM has big difference  Transaction cost is relatively higher for EM and for foreign investors  It is widely accepted that illiquid assets and assets with high transaction costs generally trade at a discount to their expected cash flow  EM illiquidity premium tends to decline once the market is opened up to outside investors  This could be one of the reason why Korean stocks are traded at discount to developed markets [...]...Poor Investor Protection  One thing that could be found easily in EM is lack of protection from investor expropriation, especially foreign investors  Controlling shareholders expropriation problem is the major corporate governance issues in EM  Lower dividend payout, wealth transfer from shareholders to controlling shareholders, restrictions on voting rights, lack of independence of the BoD, etc  Investors... the corporate governance practices in each EM countries  Over the past 20 years, there were many cases like this happening in many EM and even developed markets  Across the globe, capital markets are becoming more integrated, and this increasing integration is reducing synchronicity of EM Typical EM Practices  Although corporate governance practices are improving, typical EM countries have some... uses its control for perquisite consumption 2 Company shares are owned by another company that exerts control similar to Keiretsu System in Japan 3 Creditor rights are often strong to the detriment of shareholders  Legal system is also generally weaker in EM in terms of protecting minority shareholders especially foreign investors  Nationalism could provoke un-realistic problem for foreign investors... should understand EM legal system in order not to be  Nationalism sometimes provoke serous anti-foreign investor sentiment which will limit foreigners’ investment in EM Corporate Governance matters…  EM countries companies tend to have less transparent corporate governance compared with developed market  As corporate governance is important for investment returns EM investing return could be affected... J-Power to draw up detailed plans addressing profitability and capital spending TCI requests to include external board members, a reduction in director compensation, to sell off shares held under crossholding arrangements and to accept two Children Investment's officials as outside directors Apr 2008 TCI's request is rejected on grounds that TCI has presented a one-sided view (Yen) 7,500 6,500 5,500... (Won) (원) 301,000 251,000 Jul 2005 On Jul 15, Sovereign sell all of SK shares, or 14.82%, over the counter to an anonymous buyer at KRW49,011, 7% discount off the day's closing price of KRW52,700 Profit earned from the sellout is estimated to be KRW800 billion Apr 2003 Sovereign acquires 6.14% of SK shares in March and 8.85% in April, totaling 14.99% and KRW176.8 billion in gross amount 201,000 151,000... Shinhan Bank acquires 2.3% of KT&G shares OTC Dec 2006 Icahn coalition sells 4.75% of KT&G shares at a 3.8% discount from the closing price of the previous day at KRW 60,700 per share Oct 2007 KT&G acquires KRW 202billion of treasury shares (Won) (원) 81,000 71,000 Mar 2006 KT&G appoints Lichtenstein as external board director 61,000 51,000 41,000 31,000 Feb 2006 Icahn coalition suggests acquisition... minority shareholders especially foreign investors  Nationalism could provoke un-realistic problem for foreign investors  Improvements in corporate governance of emerging market companies increase shareholder wealth, company valuation, and investor interest Midopa vs Peregrine: 1997 (주가) 97년 2월 24일 미도파 400억원 규모의 공모 신주인수권부사채 (BW) 발행 (거래량) 50,000 Volume 2,600,000 Price 40,000 2,100,000 30,000 97년 1월 외국자본(동방페레그린... buys 13 million shares, or 10% of total available shares, of treasury stock at KRW66,400 each at the same time it announces plans to sell KRW470 billion to improve its financial structure Apr 2007 Former SK spins off petrochemical unit SK Energy Jan 2007 SK forms a strategic partnership with JX Nippon Oil & Energy and buys each others shares, 1% SK share to 0.98% JK Nippon share ratio (Won) (원) 301,000... presented a one-sided view (Yen) 7,500 6,500 5,500 4,500 Dec 2007 UK-based activist fund TCI demands J-Power to improve corporate governance, to boost shareholder returns and sell cross-shareholdings as part of its business proposal 3,500 2,500 1,500 2007-01 2007-07 2008-01 2008-07 2009-01 2009-07 . Significant information inequities in EM among investors  Many of the institutional mechanisms for information dissemination in developed markets are commonly missing in EM as individual investors. Theories Emerging Market Finance CAU MBA CAU Wonil Lee, Ph.D, & CFA New Perspectives on Investing in EM April, 2015 What makes investing in EM unique?  Should diversification always. information asymmetry in EM between insiders and outsiders  This information asymmetry create an uneven playing fields that fundamentally affects investing decisions. Insider Trading