Avoiding Political Risk In Overseas Investments

We’ve always had concerns about so-called Emerging Market (EM) funds and have never included them in our portfolios. This blog covers some of the issues associated with EM funds and their performance and asks whether it justifies the risk. We also mention what we hold instead.

Political Risk

Fund managers have underestimated the political risk associated with several countries. They invest in particular countries that do not have written constitutions, and power in the country is concentrated on a few people. Checks and balances in the US and many European and Developed Asian countries do not exist in countries like Russia and China. Investing overseas requires fund managers also to be students of history. Those who understand history are more apt to understand what happens in countries like Russia and China. Political risk cannot be quantified mathematically, as can volatility risk; it can only be assessed by those with that grounding in history and what has happened in the past; think Germany and Italy in the 1930’s as an example. Many fund managers and investors are lulled into a false sense of security since the risk may not appear for decades, but when it does; appear, it can be devastating.

Emerging Markets Funds: Why Do Investors Include Them in Their Portfolios?

Advisors and Investors have included them in their portfolios for a couple of reasons; they do have a “correlation” with domestic markets that is less than 1.0 meaning their price movements are not entirely synchronized with US investment, helping to improve portfolio “efficiency.” There has also been a belief that their return may be higher than US investments because many so-called developing countries may experience higher GDP growth. The US and many developed markets’ economies only grow at 2-3% per year, perhaps developing markets may grow much faster as their economies are modernized and enter global markets. We also think some of their inclusion in investor portfolios is a “fad.”

How Are they Invested?

The average EM fund has 28% of its holdings in China (some are as high as 35%) and 4-5% in Russia. According to Morningstar, EM funds that have holdings in Russia lost over 6% through early March as the world placed sanctions on Russia for invading the Ukraine; sanctions that will severely damage the Russian economy; restrictions were also placed on trading Russia stocks. Here from Morningstar is the geographic distribution of the average EM funds holdings:

We are concerned about their holdings not just in China but also in countries that may be attacked or threatened by other countries, particularly Taiwan and South Korea. We fear we may be entering a dangerous time, a time to avoid risks that are hard to quantify.

What We Hold

Instead of emerging markets, we hold International Small Cap Value (DFA International Small Cap Value). It does improve portfolio efficiency though its correlation is not quite as low as EM is with US investments. We are willing to give up a bit of the “efficiency” enhancement because of the lower political risk in the funds holdings; they have nothing in China and Russia. The performance has also been at least as good as, if not better than, many of the EM funds.