Investors’ Long-term Quandry

Real Estate, Savings Accounts, Bonds, Stocks, Mutual Funds, ETFs

What Will Be The Next Investment Vehicle?

by Elliott Morss, Morss Global Finance

Introduction

Over the years, we have been treated to new investment vehicles every century/decade or two. Since cave man days, there has been real estate. Banks brought us savings accounts, followed shortly by brokers selling bonds and stocks. We then heard that placing large bets on individual stocks was too risky so we invested in mutual funds. And when we got the news that most mutual funds underperformed their closest index, we bought ETFs. At least that is what happened in the US and most of the developed world. But how about emerging market countries? Will they follow the same path?

A very interesting study was done on this subject several years back by McKinsey & Co., and much of the data that follows comes from their report. The question is relevant inasmuch McKinsey estimates that emerging market countries already own 21% of global financial assets and projects that by 2020 they will own 36%. And if you add in real estate, they are already the world’s largest asset holders. In what follows, I discuss several aspects of this continuing transformation and offer some hypotheses for the future.

Household Assets

Table 1 gives estimates of the relative importance of the different asset holdings of households. While real estate is the largest asset holding in both Germany and India, financial assets are more important in the US, as are its supporting services, both pension funds and insurance companies.

Real estate would be even less important in the US (14%) if mortgages were netted out. My sense is that real estate constitutes at least 50% of household assets in most emerging market countries. While financial markets are developing rapidly in China, many city dwellers even today purchase real estate for capital gains rather than equities.

Source: McKinsey & Co.

Financial Investors – Who Are They?

Table 2 indicates that today’s investors differ significantly by country. Several things stand out:

• Households in China control a much smaller share of financial assets than in the developed world. Governments, state enterprises and corporations control a lot more. This is also true for many other emerging market countries. State enterprises play a far more important role in these countries than in the West, e.g., 6 of the 10 largest oil companies are state-owned.

• Sovereign wealth funds are large, with assets of $4.3 trillion. 37% of them are in the Middle East, 16% in China and 26% in other Asian countries.

• The US is notable for the size of its “supporting” financial institutions – the pension and insurance companies.

Source: McKinsey & Co.

Investment Vehicles

So how does the world invest its financial assets? Table 3 provides the answers. And here again, there are several notable features:

• Asian and Latin American households appear quite conservative by Western standards by holding their assets in cash or deposits. Of course, this in part reflects the absence of alternative investment vehicles.

• The US has a far larger share of its financial assets in equities than any other part of the world.

• Emerging market central banks have conservative holdings. Sovereign Wealth Funds, in contrast, have even more of their funds in equities than even the US. This in part reflects Western financial management practices.

Source: McKinsey & Co.

Another McKinsey report provides a somewhat different view of capital and debt markets (Table 4). Here we see how a country’s stock market capitalization compares to various loan and debt totals. Japan’s public debt is quite striking. Its stock market has declined over the last 20 years so households have purchased low-yielding government debt. In China, there is very little public or private debt aside from the high volume of bank loans that have gone primarily to state enterprises. The US is notable for its high level of securitized loans. Yes. Those are the loans banks make without regard to risk and sell off for fees….

Source: McKinsey & Co.

Investment Vehicles Revisited – Equities, Mutual Funds and ETFs

Table 5 traces the evolution of investment vehicles. In 1995, stock brokers ruled the roost. By 1995, mutual funds had started their domination. The latest vehicle – ETFs – has grown rapidly in recent years. 2007 was the peak for equities and mutual funds globally and in the US. In the US, ETFs have continued to grow and cut into mutual fund dominance.

Source: Investment Company Institute, Federal Reserve, Flow of Funds

Investment Implications

What if anything does all this tell us? One could see the US evolution from property to savings accounts to equities to mutual funds to ETFs happening in the developing world. Let’s hope they learn something from Western banking fiascos with securitized loans and sovereign debt – don’t let banks sell off the loans they make!

There is also the question of ETFs versus mutual funds. As I have suggested in an earlier piece, there are times to prefer one over the other.

Then there is the broader issue of what will happen to equity markets. In the first McKinsey piece cited, it is argued that by 2020, there will be an “equity gap” of $12.3 trillion where gap is defined as financing needs (mostly in emerging market countries) not covered by equity markets. One wonders. But it is clear that at least in the US, financial mechanisms labeled as “private equity” and “hedge funds” are buying up listed companies.

Right now, Western nations own 85% of all equities. Their purchases and sales pretty much determine what happens to equity prices in the developing world. And as I have noted, when financial panics occur, as they have with great frequency recently, Westerners sell their emerging market stocks off first. The result? Much wider swings in emerging markets than in Western stocks. Growing equity ownership in emerging markets should dampen the “betas” somewhat, but it will take time.

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About the Author

Elliott Morss has a broad background in international finance and economics. He holds a Ph.D.in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance