We are sometimes asked why emerging markets are so much more volatile than developed markets.  The answer is that, due to their relative size, money flows between them cause most of the volatility effect.

Consider a real world situation that most of us have seen — a stream emptying in to a pond and another stream at the the other end of the pond draining the overflow.

Think of the streams as the emerging markets and the pond as the developed markets. Think of the water as money.

The water in the stream feeding the pond moves quickly.  When the water enters the pond, it slows as it spreads out in the breadth and depth of the pond.  When the water enters the stream draining the pond overflow, it moves quickly again.

The streams are narrow and shallow by comparison to the pond, which is broad and deep.  Any fixed amount of water moving through the streams must move more quickly than the same amount of water moving through the pond between the two streams.

Today, the developed markets free-float (represented collectively by Vanguard Total Stock Market VIPERs (VTI), iShares MSCI Canada Index (EWC) and iShares MSCI EAFE Index (EFA)) is about nine times the size of the emerging markets free-float (represented by Vanguard Emerging Markets Stock VIPERs (VWO)). Within the total equity allocation of all investors, an increase or decrease in the developed markets allocation will show up as a magnified opposite change in the emerging markets allocation.

If investors decreased their current 89% developed markets allocation to an 88% allocation (a minimal change), the emerging markets would change from 11% to 12% (a substantial change).  The inverse changes are similarly minimal for developed markets and substantial for emerging markets.

The comparatively minimal nature of the developed markets changes create only minimal supply-demand pressure between money and shares, whereas the comparatively substantial nature of the corresponding emerging market changes create substantial supply-demand pressure between money and shares.

The greater the supply-demand pressure, the greater the degree of price change.

Considering the current 9:1 developed-to-emerging markets ratio, if the current bear market causes collective investors to become more risk averse and to significantly reduce their emerging markets exposure in favor of developed markets, the emerging markets would be crushed.

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Richard Shaw

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