Stuck in a bubble and blind to frontier risks

For some reason many fund managers, including those with frontier and Middle Eastern funds, were unable to comment on the wave of protests engulfing North Africa. A large number of them were evidently “travelling”.

No doubt the excuses were genuine but it is hard to resist the conclusion that if the news was good some would find a way to comment.

It is hard to believe that many fund managers did not have access to a mobile phone. Perhaps they simply did not want to be associated with a bad news story or maybe they felt they did not have the necessary expertise.

”Political risk is only one of the risks in emerging markets that is being under-estimated”

In any case the recent unrest in the Middle East raises important questions about emerging markets funds. In particular whether the political risk embodied in such markets is being underestimated. Investors have piled into such funds recently on the back of strong market performance but they may be too sanguine about the potential dangers.

Of course fund managers will attempt to reduce such risk through diversification. But when a large part of an entire region is troubled the impact can still be marked.

This is not to say that frontier funds or Middle East funds are necessarily bad investments. But the managers should be conversant with the risks involved. The key potential dangers should also be transmitted to investors. (article continues below)

Indeed political risk is only one of the risks in emerging markets that is being underestimated. The danger of a debt bubble developing in the region is substantial. Liquidity from the West, no doubt some of it originating in quantitative easing programmes, is playing a key part in this trend.

Fund managers and investors are so focused on short-term returns and immediate past performance that they seem to be downplaying such risks. In that respect they are exhibiting classic bubble behaviour.

In some respects this is reminiscent of the discussion of equities in the years before the economic downturn of 2007-08. Back then it was often assumed that the “great moderation” of relatively stable economies meant it was no longer necessary to consider more fundamental economic questions.

None of this is to argue that fund managers or investors should not take risks. On the contrary, without a degree of risk there can be no returns. The point is that they need to be aware of the risks that they are taking.

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Ferraris For All, Daniel’s book defending economic progress, was published last year. His personal website can be found at www.danielbenami.com.