By |Published On: July 16th, 2015|Categories: Book Reviews, Tactical Asset Allocation Research|

A recent IMF World Economic Outlook survey projected that in 2015-2016 advanced economies will grow at 2%-2.5% rate, while emerging and developing markets are growing at a more robust 4%-5%, led by India and China, growing at 7% and 6%, respectively. Indeed, the conventional wisdom is that emerging markets, growing at perhaps double the rate of advanced economies, will lead the ongoing recovery and that we should expect them to exhibit the highest growth rates in the world over the long run.

With such encouraging growth potential, why not go all-in on emerging markets?
While this is compelling logic, the great potential of emerging markets must be balanced against the potential risks. These risks are related to various restrictions on the free flow of capital that exist in these markets. In “Cracking the Emerging Markets Enigma,” Andrew Korolyi attempts to identify and quantify six classes of risk in emerging markets, which allows investors to distill overall risk to a single number, enabling comparison across all countries, from emerging to advanced, and inform allocation decisions.

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It’s a bold undertaking, but Dr. Korolyi certainly has the credentials to back up the attempt. Andrew Karolyi is an internationally known scholar, and a professor at Cornell’s Johnson Graduate School of Management, and has done extensive research into international investment management. In many ways, this book is a synthesis of the many research papers he has published, and the culmination of the many years of study he has devoted to emerging markets.

Karolyi presents the overall framework, and then offers a separate chapter to explore each of the six risk factors he identifies. Along the way, he takes us through the voluminous academic research in these areas and offers great local case studies that highlight the issues at play.

What I like about the book?

I enjoyed the balance Karolyi sought and achieved in presenting both the big picture, as well as a more granular discussion of the various dimensions of risk. The book’s scope and broad reach across the many areas of risk that international investors face provided me with a new perspective on emerging markets investing. Institutional and retail investors alike can benefit from exposure to the body of academic research upon which Karolyi draws, and which he carefully organizes for us. Although each risk area is practically a field of study unto itself, Karolyi takes us through each one in detail while describing his methodology.

Market Capacity Constraints

First up is market capacity, which relates to a country’s domestic credit markets, the size of its equity and bond markets, the number of listed companies, and trading volumes and liquidity. These factors collectively facilitate the efficient allocation of capital and financial development of a country. The output from the model is fascinating. I learned that Venezuela is terribly constrained, with weak credit markets, no bond markets, and a tiny illiquid stock market versus its GDP. By contrast, Taiwan has established bond markets, and has many participants in its vibrant equity market, which is larger and more liquid than those found in many developed economies.

Operational Efficiency

Operational efficiency relates to the various transactional costs involved when trading in these markets. These include explicit trading costs, such as commissions, fees and taxes, as well as implicit costs such as bid-ask spreads, market impact costs, market depth and breadth considerations, other measures of market liquidity, restrictions (such as on short selling), clearing and settlement systems, and market integrity.

Restrictions on Foreign Accessibility

This risk category involves capital controls generally, and the direct legal and indirect practical factors that affect foreign investment. Direct factors include consideration of investor frictions such as foreign investor registration requirements, currency convertibility, and withholding taxes. Indirect factors include “hassle” factors such as ownership restrictions, taxes, or position limits for foreign investors. These kinds of restrictions impose costs on foreign investors, and are a deterrent to investing.


Transparency as a risk factor has to do with corporate governance practices within countries. Governance issues include things like minority shareholder rights, disclosure standards, board structure and independence, the existence of large blockholder interests, and analyst coverage. Another interesting way to view transparency is via “synchronicity,” which describes how stocks in a market commove together. China scores especially poorly on this measure, which contributes to its dead last ranking in corporate transparency.

Legal Protections for Investors

This measure of risk deals with the structure and attributes of of a country’s legal system. It includes consideration of the general environment of law and order, minority shareholder rights, creditor rights, dispute resolution mechanisms, and regulatory and supervisory powers. These legal protections, or lack thereof, can protect shareholders, or limit their ability to pursue action.

Political Instability

Many investors consider political stability to be a primary source of risk when investing. Measurements of political stability might include constraints on policy change, and commitments to business and real estate ownership. Karolyi also considers inputs for civil unrest, violence and corruption.

It’s quite a ride through these risk factors, but be have unifying theme at the end bringing the analysis into focus for the reader. At the end of the book there is a great chapter that discusses how well the model describes investor behavior. Karolyi shows how global investors allocate, and observes that his model better describes holdings of non-US investors than it does for US residents. He then goes on to test the model out of sample, in the emerging market swoon of 2013, which sheds some light on which risk areas investors appear to have prioritized at that time. It’s an absorbing analysis, and while it clearly explains a lot of what occurs in emerging markets, it also raises some interesting questions about how investors allocate and why.

Constructive Criticism

I found Mr. Karolyi’s style to be somewhat overly academic at times. For example, he attempts to assess his risk measures by comparing the predictions of his model to how global investors actually allocate to different emerging markets, including a discussion of home bias and foreign bias. So does his model explain how investors allocate? Well, yes, it does a reasonably good job, as the regression yields an R-squared of 20%. Yet, what are we supposed to make of this data? Sure, we can see the implied home and foreign bias, and that U.S. investors under-allocate to Chile, but what exactly does this tell us about the integrity of his risk framework? Is the goal of the model to predict how investors allocate? Why should this be a basis for determining whether the model “works?” Given various biases, perhaps we could conclude that his model offers a better way to measure risk, and therefore investors may be misallocating?

I was looking for more help with these questions, although perhaps we’ll see more as Karolyi does follow-on analysis in the years ahead. The methodology is also just generally academically dense, with casual references to obscure statistical methods and math terminology such as “eigenvalues,” which is term I forgot shortly after taking linear algebra in high school in the 80s. Yikes. Maybe this lowly Wharton MBA is in the wrong book.


While this book is probably better geared for the more academically inclined, or for institutional investors, the comprehensive risk framework Karolyi presents is well-reasoned and is generally comprehensible to the lay reader. While I was familiar, at least anecdotally, with many of the issues covered in this book, it was fascinating to see a quantitative mind attempt to corral these issues in a coherent way, and integrate them into a general framework. And while big picture is great, the detail is also quite stunning. Thinking about investing in Slovenia? You may be surprised to see it ranks ahead of Japan and Germany for governance and corporate transparency.

Another takeaway I had after reading this book is that while we tend to lump countries into different buckets, each with a descriptive label that describes its risk, the truth is that risk measures are much more fluid and have more gradation than we assume. A country that is labelled as an “emerging market” may not be an emerging market from a risk standpoint. And Koralyi’s model seems like a reasonable place to start for thinking about these issues. I look forward to seeing what Koralyi delivers in the form of additional out of samples tests as the future unfolds.

Finally, this book is a great addition to the bookshelf for the educated investor.

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About the Author: David Foulke

David Foulke
David Foulke is an operations manager at Tradingfront, Inc., a provider of automated digital wealth management solutions. Previously, he was at Alpha Architect, where he focused on business development, firm operations, and blogging on quantitative investing and finance topics. Prior to Alpha Architect, he was involved in investing and strategy at Pardee Resources Company, a manager of natural resource and renewable assets. Prior to Pardee, he worked in investment banking and capital markets roles at several firms in the financial services industry, including Houlihan Lokey, GE Capital and Burnham Financial. He also founded two internet companies, E-lingo, and Stonelocator. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.

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For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

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