By: Frank Armstrong
China has a huge land mass, lots of people, tons of cash reserves, an enviable trade surplus, and is one of the world’s largest economies. So, there ought to be lots of investment opportunities for our portfolio, right? No, actually there are quite few investment opportunities for you and I there.
To optimize our equity portfolio ideally we would want to hold our little portion of all the world’s enterprises. But, since you and I don’t have a few billion dollars to plunk down in China for a direct foreign investment as did Google, and GM to name just a couple, we have to rely on freely traded stock and a robust securities market.
We can use China or Russia as examples of how a giant economy offers small investment opportunities. A huge proportion of their enterprises are owned by the Communist Party, military, or other state entity. Their shares don’t trade and cannot be purchased. Many of their facilities are antiquated, inefficient, bloated and produce articles that nobody wants. So, even if the governments wanted to spin them off, they are hardly desirable as investments. Such are the joys of central planning coupled with endemic corruption. Schumpeter’s creative destruction hasn’t yet had a chance to clean them out of the system. Still other companies are privately held and many attractive startups are not ready for an IPO. The net result is that there are few stocks to trade in China or Russia relative to other measurements that would indicate their world power status. South Korea and Taiwan both have markets about as valuable as either China or Russia.
As you can see from the chart, market capitalization may have little relationship to GDP, population, trade, wealth or land mass. The chart simply illustrates the size of the free float adjusted stock markets to the total world capitalization. It doesn’t look much like the maps we are used to.
But, there are other challenges for global investors as they design their asset allocation:
- Political and/or military risks may be too high to bear.
- Without a rule of law to arbitrate disputes and respect for property rights markets are unlikely to function properly or at all.
- Many countries that have functioning markets are still so small that relatively tiny cash flows can swamp the entire country and liquidity is not available for institutional investors.
- Finally, some smaller markets may not have the technology or institutions to efficiently regulate, process and account for transactions.
While we might aspire to perfect global diversification in our portfolios, we are somewhat constrained in the real world. But, by focusing on where the investment opportunities actually are we can focus on developing a rational, strategic, disciplined approach to our asset allocation decisions.
Fortunately, today we can economically and effectively capture a high majority of the value of the world’s developed and emerging markets using only a handful of index funds and/or Exchange Traded Funds. As markets further mature, additional opportunities to diversify will emerge allowing investors to put their capital at work where they are offered the most attractive returns.