Emerging Markets Investing Requires Multi-Asset Class, Horizontal Approach

The Unseen Architecture of Emerging Markets: Why Diversification is the Only Constant

This conversation with Nick Rohatyn, CEO of The Rohatyn Group, reveals a fundamental flaw in how institutional investors approach emerging markets: a rigid adherence to single-asset class, siloed thinking that is ill-suited for the dynamic and inherently fragmented nature of these economies. Rohatyn argues that this "developed market construct" imposed on emerging markets leads to capital misallocation, failing fund managers, and ultimately, a missed opportunity for both investors and the developing nations themselves. The hidden consequence is the perpetuation of a system that prioritizes familiar, yet inadequate, structures over the adaptive, multi-faceted approach required for genuine success. Investors who grasp this non-obvious implication--that true EM investing demands a horizontal, multi-asset class perspective--gain a significant advantage by aligning their strategies with the underlying reality of these markets, rather than the artificial constraints of conventional wisdom. This analysis is crucial for institutional allocators, fund managers, and anyone seeking to navigate the complexities of global capital with a more robust and effective framework.

The Tyranny of the Mono-Asset Class: Why Silos Crumble in Emerging Markets

The prevailing wisdom in institutional investing often dictates a clear separation of asset classes: private equity here, public equities there, fixed income somewhere else. This structured approach, honed in the predictable environments of developed markets, becomes a significant liability when applied to the volatile and diverse landscape of emerging markets. Nick Rohatyn argues forcefully that this imposition of a "developed market private investing construct" onto emerging markets is not just suboptimal, but fundamentally flawed. The core issue, he explains, is that the deal flow and market dynamics in emerging economies simply cannot support the rigid, single-asset class, often regional, funds that dominate the landscape.

This mismatch creates a cascade of negative consequences. Fund managers, bound by their specific mandates, are forced to deploy capital into suboptimal opportunities simply to meet deployment targets. This leads to "deploying it badly," as Rohatyn puts it. Compounding this problem is a prolonged period of currency depreciation, which further fragments the market and contributes to a proliferation of "failing GPs." The result is a competitive landscape where small, under-resourced funds struggle against the behemoths of US leveraged private equity, a battle they are destined to lose.

"The world has imposed a developed market private investing construct on emerging markets, which is to say the vast majority of investment vehicles in emerging markets are mono asset class. It's either private equity or it's private credit or it's infrastructure. Many of them are regional or sub-regional, and that is a terrible way to invest in emerging markets."

The implication here is profound: conventional success metrics and structural approaches from developed markets actively hinder, rather than help, in emerging markets. The "advantage" gained by adhering to these familiar structures is illusory, masking a deeper dysfunction. Rohatyn's own experience, building TRG as a multi-asset class, horizontal firm, directly challenges this orthodoxy. He recognized early on that emerging markets are inherently "horizontal activities," requiring an integrated approach that transcends artificial silos. This strategic foresight, born from observing the limitations of a big institutional setting, allowed him to build a firm designed to address the actual needs of the market, rather than fitting the market into pre-existing boxes.

The Benchmark Trap: When Indices Lead Investors Astray

A critical component of institutional investing is benchmarking, a practice that, according to Rohatyn, becomes a significant impediment in emerging markets. The reliance on benchmarks, particularly in long-only strategies, simplifies decision-making for allocators by providing a clear performance yardstick. However, Rohatyn meticulously dissects the inherent flaws in common emerging market benchmarks, revealing how they can lead investors astray.

In emerging market equities, for instance, the MSCI indices are heavily concentrated in just a few countries, meaning a supposedly diversified "emerging market equity" investment is, in reality, a concentrated bet on a handful of economies. This is far from the broad diversification investors believe they are purchasing.

The issues are even more pronounced in fixed income. Rohatyn highlights the limitations of hard currency benchmarks like the EMBI, noting that the corporate bond market in emerging economies is vast but fragmented and illiquiquid, making it difficult for index construction. More critically, he points to the local currency government bond index (GBI-EM), which he helped pioneer. While intended to provide a benchmark, its construction presents several problems. Firstly, it focuses solely on government bonds, ignoring the much larger and more dynamic fixed income market that includes swaps, forwards, and FRAs. Secondly, the selection of the "most liquid part of the curve" in each country leads to wildly inconsistent duration exposures. Thirdly, and perhaps most significantly, the benchmark is dollar-denominated, yet many of the underlying bonds are not. This means returns are heavily influenced by volatile currency pairs like USD-EUR or USD-JPY, obscuring the true performance of the local currency investment.

"If you don't take that into account, then a lot of what you are investing in in the ELMI is dollar-euro, dollar-yen volatility."

This analysis underscores a key systemic insight: benchmarks designed for developed markets, or even early attempts at EM benchmarks, fail to capture the nuanced realities of these economies. Investors who blindly follow these indices are not only missing opportunities but are also exposed to risks they do not understand, particularly currency volatility. Rohatyn advocates for a "benchmark agnostic" approach, suggesting that by systematically overcoming these index limitations--for example, by using a consistent duration benchmark or a logical currency overlay--investors can construct passive strategies with superior risk-adjusted returns. This requires a departure from the comfort of established indices and an embrace of a more analytical, adaptive strategy.

The Horizontal Advantage: Building Scale Through Integration and Acquisition

Rohatyn's entrepreneurial journey, from his early days at JP Morgan to founding TRG, is a masterclass in building a firm designed for the specific demands of emerging markets. He recognized that the "silo inertia" within large institutions would always be a threat to a truly integrated emerging markets strategy. This led him to establish TRG not as a specialist in one asset class, but as a "solution-oriented firm" capable of offering a horizontal approach across multiple asset classes and geographies.

The strategic imperative driving TRG's growth, particularly post-financial crisis, has been scale, achieved primarily through acquisitions. Rohatyn observed that allocators, post-2008, overwhelmingly favored larger managers, creating a "1% of the population getting 95% of the dollars" dynamic. This realization shifted his focus from purely organic growth to a more aggressive acquisition strategy. He sought out firms that already possessed established LP relationships and proven track records, aiming to integrate their capabilities into TRG's broader platform.

"Scale mattered. The notion of, 'Oh, I'm going to start something the old-fashioned way. I'll hire a team that does XYZ.' I tried it in Africa, for instance. Hire four people, spend two years trying to raise money. You raise some money, but it's conditional on other money. It wasn't going to work."

This approach, while fraught with cultural and integration challenges, as evidenced by the Citigroup acquisition, has been instrumental in building TRG's diverse capabilities. The key to successful integration, Rohatyn emphasizes, lies in a consistent message about the firm's vision, a collegial management style with distributed decision-making, and widespread equity ownership. This creates a cohesive unit where different capabilities can cross-pollinate, leading to enhanced insights and a more robust risk management framework. The "horizontal advantage" is thus not just about offering multiple asset classes, but about creating an ecosystem where diverse expertise can thrive and adapt, providing a durable competitive edge in the inherently cyclical and unpredictable world of emerging markets.

Key Action Items

• Immediate Action (0-3 Months):

  • Re-evaluate existing EM mandates: Critically assess whether current single-asset class or regional allocations are appropriate for the realities of emerging markets, considering Rohatyn's critique of benchmarks and siloed approaches.
  • Investigate currency management expertise: Ensure your investment teams or partners have robust capabilities in currency hedging and overlay strategies, recognizing currency liquidity as a crucial risk management tool.
  • Analyze portfolio diversification: Map the geographic and asset class concentration within your emerging markets exposure, identifying opportunities to broaden diversification beyond the largest economies or most popular asset classes.

• Short-Term Investment (3-12 Months):

  • Explore multi-asset class solutions: Begin researching and engaging with managers who offer integrated, horizontal investment strategies across public and private markets in emerging economies.
  • Develop scenario analysis capabilities: Shift risk assessment focus from standard deviation to scenario-based analysis, particularly for emerging markets, to better anticipate and prepare for extreme events.
  • Build relationships with diverse EM managers: Cultivate connections with a range of managers, including those who may operate outside traditional silos, to gain broader market perspectives.

• Long-Term Investment (12-18+ Months):

  • Consider strategic acquisitions or partnerships: For asset managers, explore opportunities to acquire or partner with firms that complement existing capabilities and enhance scale, particularly in under-penetrated regions or asset classes.
  • Advocate for structural reform: If in an allocator role, champion the adoption of more flexible, multi-asset class mandates for emerging markets to unlock greater capital deployment and impact.
  • Focus on integrated platform development: For firms operating in EM, prioritize building a cohesive, cross-functional platform that fosters collaboration between different asset class and regional teams, creating synergistic advantages.