Convergence and Beta

One thing that many people in finance do not fully understand is economic convergence. The dominant assumption seems to be that absolute convergence holds - the less developed a country is the more it will grow. The first decade of the 2000's has done little to dissuade this view. Investors focusing on the BRICs have been very profitable. Brazil, Russia, India and China have relatively functional institutions compared to the rest of the emerging world, and their resources and human capital have justified a level of bullishness on them. Other countries such as the Next 11 or the CIVETS (There is some overlap) are seen as the next group of countries for emerging investors to focus on.

Absolute convergence of these countries is basically taken as a given by investors looking at these groups*. In reality, the political instability in many of the countries makes the convergence of all of these countries unlikely. Some of these countries are probably going to grow at a high rate, but without improved institutions many will stagnate and some will regress in the face of economic and political instability. 

Investors counting on convergence to work like magic are comfortable with the framework of convergence in part because they are comfortable with the notion of beta. High risk countries are supposed to make them  money the same way that high risk stocks do. However, these investors don't realize that beta doesn't always work in the long run as even though there is an equity premium low beta stocks outperform high beta stocks. The same is likely true for convergence, so the countries with the highest room to converge really might be like high beta stocks - lottery tickets that will under perform.

This analogy suggests that those looking to go long emerging markets should at the very least err on the side of going long more developed emerging countries where the political risk is less extreme.

*The people who made the groups did try to pick countries with positive fundamentals but there aren't that many countries so they are bound to make some bad choices.

About

I studied Bioengineering at the University of California at San Diego. While there I served as a trustee on the investment committee of the UCSD Student Foundation, a group that manages an endowment to fund scholarships. While in college I applied my interest in finance and economics by working as a summer associate at Clarium Capital Management, working part time my senior year, and joining full time when I graduated in 2006, staying there through August 2010. I am currently working as a portfolio manager at another global macro hedge-fund in the Presidio (And blogging about more directly market related ideas at their restricted blog). I’ve been focusing on quantitative finance, currencies, commodities, the interplay between finance and politics, demography and other long term trends.

Disclaimer: You shouldn’t consider anything on this site to be a recommendation or solicitation to buy, sell, or hold any securities or commodities. I’m not offering you investment advice. I or the company I work for may hold positions in securities that I mention.