beyondbrics

Developed world investors in emerging market equities funds might be surprised how their recent returns have actually been generated, as a report in Monday’s FTfm explains.

While those investors might picture gains earned largely from appreciation in share prices of companies with emerging market business activities, James Wood-Collins, chief executive of Record Currency Management, estimates that since 1998 currencies have accounted for between a third and half of the returns UK-based investors have earned from emerging market equities.

“There has been a lot of attention on emerging market asset investing, but what is still less understood by investors is how much of the returns are driven by currency, rather than the underlying assets,” he says.

Cue: fund managers waiting in the wings waiting to spot relatively low-risk emerging market plays.

The rationale behind their enthusiasm for an emerging market currency investment strategy is provided by the work of two economists in 1964, Bela Balassa and Paul Samuelson. They independently observed that average prices should be higher in countries with higher gross domestic product per head.

In terms of currency investing this would mean going long emerging market currencies and shorting their developed world counterparts.

“As Asia develops we do think that should lead to stronger real exchange rates,” says Bilal Hafeez, global head of FX strategy at Deutsche Bank.

“Everybody is absolutely convinced of it. If emerging markets have higher productivity growth than the developed world, they should get wealthier relative to us and their call on world assets should go up relative to us,” says David Bloom, global head of FX strategy at HSBC.

If this is beginning to sound like a free lunch, here’s the snag. Timing the revaluation of emerging market currencies gets a little more tricky and has been the subject of much academic investigation. Emerging market policy makers are not keen to allow big step appreciations.

“The empirical evidence is mixed. We wouldn’t rely on Balassa-Samuelson alone to steer a currency view,” says Deutsche’s Hafeez.

This is not deterring Record Currency Management. Despite the risks of intervention, inflationary monetary policy and asset price bubbles, it launched an EM Currency Fund, which holds long positions in 13 emerging currencies and shorts in four developed world ones, in December to benefit from the Balassa-Samuelson effect.

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