What could be a safer investment to recommend to your clients than Coca-Cola? It's just some nice sugar-water that everybody around the world likes to drink. Wait a minute--boycotts are erupting at upper tier schools like the University of Michigan because of Coke's alleged improprieties in Colombia. Then to diversify, you invest in the white-hot emerging markets sector, but now the experts are warning about a possible collapse in these funds. Then you realize you just put your clients into Alcatel, a giant French telecommunications company. Oh, no, Alcatel invests in--what?--Sudan.
"There isn't a single company that I can think of that doesn't have an international exposure," says Katie Weigel, who runs LongPoint Financial Planning in Concord, Mass.
In today's investment world where everything is global, how can financial planners guard against exposure to potentially mountainous problems in emerging market funds or old favorite stocks now internationally entangled?
For instance, on Jan. 1, 2006, the University of Michigan removed Coca-Cola Co. products from campus, becoming the 10th school to enact a ban. At Michigan, Coke-related sales totaled $1.4 million in 2005. Around the country, student activists are pushing universities to end sales of Coke products, and the boycott spread to Turin, site of the 2006 Winter Olympics, where Coke was a prime sponsor. Activists contend the company has not done enough to halt violence against union workers in Colombia and won't agree to terms of an investigation at plants there. Coca-Cola denies the charges, and the company has agreed in principle to a third-party investigation.
These rumblings haven't yet made financial planners stop recommending Coke, but Weigel says she doesn't like Coke anyway because "Pepsi is beating the pants off Coke." Pepsi, of course, is also an international company with its own international exposure.
Exposure or not, emerging markets are the funds du jour. The amount of private capital flooding into emerging markets reached a record high of $358 billion in 2005, says an estimate from the Institute of International Finance, an organization of multinational banks, securities firms and other financial institutions.
These funds can yield excellent returns. For example, in 2005, the Morgan Stanley Capital International (MSCI) Emerging Markets Fund jumped 34.83 percent. How can you avoid investing in funds like that? But the whole asset class could be imperiled. During a news conference, William R. Rhodes, a senior vice chairman of Citigroup, specified that the previous record of $323 billion invested in emerging markets came in 1996, just before the Asian financial crisis of 1997-98. Ah, there's the rub--risk versus reward; so what's the answer?
For Katie Weigel and her husband, Eric, partners in business and life, the best way to enter emerging markets is via exchange-traded funds, which are basically index funds. That way "you are not trying to finesse in Brazil or South Korea. You want exposure to the whole asset class. With emerging markets, you are buying a basket of countries and securities. We're buying the asset class as a whole--emerging markets in general," says Eric Weigel.
For instance, the Weigels like the aforementioned MSCI Emerging Markets, an index fund that includes about 20 countries and 1,100 stocks. This is a passive investment as opposed to a fund that jumps in and out of stocks and countries.
Eric Weigel has been an investor for 20 years, and has been evaluating emerging markets funds for the last 15 years. When he selects a fund, he spends 15-20 hours a year on evaluation. "The information is available to the public about which investments and which countries are in the exchange traded funds. You can drill down and find out what the countries are and what stocks are invested. I do that for clients." Some countries send off negative vibrations. "I don't want my clients in Equatorial Guinea, a tiny African country with a ton of oil," Weigel says.
Other advisors offer similar advice. "Most good emerging market funds will not invest in the most spotty emerging market nations," says Darius G. Gagne, principal of Quantum Wealth Management in Santa Monica, Calif. "The key is to buy the 'entire' emerging asset class and fully diversify away any non-systematic company risk," he says. "There is no point in trying to hand pick enough stocks to diversify non-systematic risk or to speculate as to which firms will have a problem; just purchase the entire asset class through a fund with such an objective and capture pure market risk. The key market risk factors that the advisor wants to expose his client to are the size and value of the emerging market companies. These are the only risk factors that research has shown rewards investors properly in the long run for the risk they bear," Gagne says.
To analyze the risk of EM funds, Gagne says, "You can get 99 percent from their Website. One page will give you the top 10 holdings." Fund managers spend their working lives analyzing which countries to avoid and which to invest in. "They don't want to lose; they want to win," Gagne says. Still, the financial advisor had better make sure the fund manager's selections agree with his. "You have to do your due diligence," Gagne says. After his own review, Gagne likes Dimensional Funds for equities and the Pimco Emerging Market Bond Fund for bonds, noting for the record that he used to work at Pimco.
In Salem, Ore., Wolfgang Sailler employs his own methodology--both financial and personal--for determining investments in emerging market funds. "I check to see if the fund is trading at a premium or a discount," says Sailler, who runs his own firm, Goldmark Financial Planners, LLC. If the market price is above the net asset value, the fund is at a premium. If it's below, it's at a discount. When the Morgan Stanley Eastern European Fund reached a premium, Sailler sold--at a nifty profit.
Also, he investigates the fund's investments. "I look at their profile on the Internet," Sailler says. He wants to know where the fund is investing. What industries? What countries? Financial analysts can interview the fund experts who have actually been to these countries and know what's happening there. For instance, "I don't know anything about Romania," Sailler says.
Then Sailler can invest in an EM fund, depending on a client's comfort zone. For a younger person, a 10 to 20 percent slice of her portfolio might be proper while a person in her 50s might only want to venture 5 to 10 percent, and a retiree, worried about security, might not want to venture anything at all.
At Putnam Investments, "We have our own proprietary model judging creditworthiness of various countries, and we look at the political and macroeconomic situation," says Jeff Kaufman, managing director and senior portfolio manager for Putnam's emerging fixed income markets. Putnam, based in Boston, has several funds, all in fixed income. "We try to pick countries that are improving in creditworthiness and avoid those that are deteriorating in their economies or politics," Kaufman adds.
However, some experts see danger in all emerging market funds and heavy international investment. "I fear there's this perfect storm coming for emerging markets," says Kristin J. Forbes, a Massachusetts Institute of Technology economics professor who served on President George W. Bush's Council of Economic Advisers. "I think things will be fine for the next few months, but my worries increase at the end of the year and next couple of years."
Higher interest rates, slower economies and declining commodity prices could create this malaise that hurts emerging markets and emerging market funds, Forbes says. Many emerging nations have taken steps to ward off this problem such as strengthening their fiscal policies, but the confluence of the aforementioned events could translate into a major financial problem.
Some people think the seeds of distress have already been planted. As Desmond Lachman, a resident scholar at the American Enterprise Institute in Washington, phrased it, "even turkeys fly when the winds are strong." In plain English, that means emerging market funds managers, flush with cash and desperate for a higher yield unavailable in the United States, are pouring billions of dollars into emerging markets like Latin America, Asia and Eastern Europe. With all this money surging into their economies, that gives these counties a false impression--to themselves and the outside world--of economic stability, even strength.
Lachman, who joined AEI after serving as managing director and chief emerging market economic strategist at Salomon Smith Barney, says everything has gone incredibly well for emerging markets in terms of liquidity and higher commodity prices such as in copper and aluminum. "The game today is putting money into equities in emerging markets," Lachman says. Spreads have become so tight on sovereign debt--for example, Brazil is now at 220 basis points over U.S. Treasuries, compared with 800 bps in 2002. "Everyone is stretching for yield," he says. Hence, the surge into EM equities, but that makes it "a bubble," Lachman says. He doesn't predict an Argentine-like meltdown, but fears many people will financially jump into emerging markets at the top. "You can put your money in those stocks if you're prepared to lose it," he warns.
Amid these warning signs coming from responsible experts, financial advisors have some choices. "The due diligence for top managers is of the managers they hire, not necessarily what individual stocks the manager owns," says Scott Leonard, president of Leonard Wealth Manager Inc. of Redondo Beach, Calif. "So if one sees the current situation as a risk, then they should contact the manager of the emerging market fund as an example, and ask them exactly how they dealt with past similar situations and what their results were during situation like these in the past. (In reality, this should be part of the due diligence before one selects a manager.) However, almost always the managers are selected for recent good performance, which means they dodged the bullets in the past. The trick is to determine if they were just lucky or actually skillful, but this is a different topic altogether," Leonard says.
Twenty-five years ago, boycotts started against South Africa and its apartheid policy. Today, the new African beast is Sudan, where genocide is still occurring in Darfur in western Sudan. At least three American states--Oregon, New Jersey and Illinois--have passed Sudan divestment legislation, which prevents their state pension funds from investing in companies doing business in Sudan.
Although U.S. companies are forbidden to invest in Sudan, more than 120 publicly traded non-U.S. companies--including giants like Total SA, Siemens AG and Alcatel--do invest in Sudan. Hence, these major international firms could easily be in someone's portfolio or in an emerging markets fund.
To alert citizens and investors to this possibility, KLD Research & Analytics Inc., an independent research firm based in Boston, has started the Sudan Compliance Service, a constantly updated list of companies doing business in Sudan, along with their ticker symbols. KLD's list complies with the state of Illinois' Sudan legislation guidelines. By the end of January 2006, money managers for Illinois pension funds had to comply with recent state statutes for divestment in Sudan. The Illinois Public Act calls for all public pension funds in the state to divest themselves of companies doing business in Sudan. In turn, market fund managers have to know which companies to avoid. "I'm getting a lot of calls from money managers," says Randy O'Neil, KLD's managing director for global sales. Armed with this information, some money managers are establishing Sudan Free Indices.
The question is, will these boycotts hurt a company like Coke or Siemens? Opinions vary. "It's too early to tell," O'Neil says about companies still in Sudan. "Any reasonably related news could have an effect on the (Coke) stock," Gagne says. That's why he diversifies through EM funds.
In a global economy, diversity may be a trickier proposition than we realize.
Alan Gersten is a freelance writer based in Brooklyn.
[SIDEBAR]
[HED] Politics vs. Profit
Financial advisors invest their customers' money for profit, not social responsibility.
"Here at LongPoint Financial Planning, we do not do any `socially-responsible investing' on a regular basis," says Katie Weigel, who, along with her husband, Eric, runs LongPoint Financial Planning in Concord, Mass.
"We are here to serve our clients, and therefore, our first responsibility is to build them a portfolio that is fully integrated with their personal needs, objectives, goals and constraints," she says. "To do otherwise would leave us in a bind: What `master' are we serving...the client or some other calling? As we are fee-only and, therefore, paid by the client, they come first."
However, if a client doesn't want the firm to buy any tobacco, gambling or other such stocks for personal reasons, the Weigels honor that request, if possible. These would be specific exceptions noted in the individual client's investment policy statement. If the client's feelings are that strong about "socially responsible" investing, the Weigels recommend an advisor who specializes in that area. "Our due diligence will always be to provide the client with the best portfolio for their needs. It is that simple," Katie Weigel says.
In today's world of global investments, several large international companies--like Siemens AG, Alcatel and Total SA--invest in Sudan, a regime practicing genocide against the people of Darfur in western Sudan. American companies are prohibited from investing in Sudan, but what about international companies that do? KLD Research & Analytics' Sudan Compliance Service is a continually updated list of companies doing business in Sudan, along with their ticker symbols. Companies making humanitarian investments in Sudan are excluded from the list, says Randy O'Neil, the Boston-based independent research firm's managing director for global sales. When O'Neil calls companies on the Sudan divestment list, asking why they still invest in that country, they give him a variety of answers, ranging from "no comment" to "engagement is the best policy."
Since the Sudan divestment activity only began in early 2006, it is difficult to see any effects yet, O'Neil says. However, "These companies have to ask themselves if it's worth it to make any investment in a small operation like Sudan." He recalls the success of the South African boycott 25 years ago protesting that country's policy of apartheid.
"We look closely at the politics of a nation," says Jeff Kaufman, managing director and senior portfolio manager for Putnam Investments emerging fixed income markets in Boston. If a country is filled with political unrest, "It's less like to get funding," Kaufman says.
Wolfgang Sailler, who runs Goldmark Financial Planners, LLC, based in Salem, Oregon, doesn't equate the two boycotts and has no problem investing in a company like Siemens, a giant German firm dealing in electrical engineering and electronics which invests in 190 countries. "Siemens has 325,000 employees worldwide, including 80,000 in the United States. They don't have a homeland." Hence, Siemens is literally all over the world, but investing in business operations, not machine guns.
"I don't think they invested in (Sudan) to kill people. If they did, I would sell the stock," Sailler says.
--AG
