A IMF World Economic Outlook survey projected that in 2015-2016 advanced economies will grow at a 2 to 2.5 percent rate, while emerging and developing markets will be growing at a more robust 4 to 5 percent, led by India and China, growing at 7 percent and 6 percent, 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 shouldn’t investors 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 allow investors to distill overall risk to a single number; make comparisons across all countries, from emerging to advanced; and inform their allocation decisions.

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 finance professor at Cornell University’s Johnson Graduate School of Management, and he 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 the reader through the voluminous academic research in these areas and offers great local case studies that highlight the issues at play.

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 ConstraintsAndrew Korolyi offers a risk framework for emerging market investing

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 can move 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 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 Korolyi provides a unifying theme at the end to bring his analysis into focus for the reader—how well his model describes investor behavior. Karolyi shows how global investors allocate, and he observes that his model better describes holdings of non-U.S. investors than it does for U.S. 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.

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 a 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: 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.

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

Editor’s note: The original version of this article first appeared on AlphaArchitect.com on July 16, 2015.