Emerging markets first became popular among investors in the early 2000s. Despite some economists and investors developing reservations about these markets since then, they remain relatively popular. Over the last 20 years, various new tools and funds for investing in emerging markets have been launched. An investment in these markets provides a unique opportunity to expose your portfolio to both higher risks and higher rewards. Significant gains await investors who correctly select and time their emerging market investments. However, there are risks for those who fail to properly assess the investment risks.

What are emerging markets?

The term emerging markets refers to those economies that are between the stages of developed and developing. An economy enters the emerging-market phase when it experiences high growth, combined with above-average volatility.

During the rapid growth phase of an emerging market, it usually becomes more tightly integrated with the world economy. This can be seen from the increased liquidity in such an economy’s equity and debt markets, strong growth in foreign direct investment and trade volume, and the development of modern regulatory and financial institutions in the local market.

A critical feature of an emerging market economy is that it is busy transforming from a less developed, pre-industrial, low-income economy to an industrial economy with a relatively high standard of living. When investors and economists evaluate emerging market economies for investment purposes, they look for countries with relatively little social and political unrest as well as reliable economic growth.

Over the past few years, the most prominent emerging market economies include China, Mexico, India, Russia, Saudi Arabia, Brazil, and Pakistan.

What are the different types of risks to use when investing in emerging markets?

Non-normal distributions

When a market follows a normal distribution pattern, it is possible to use financial models to determine the prices financial instruments, such as derivatives, to make fairly accurate projections about where equity prices are heading. Examples of markets where returns follow more or less such a pattern are North America and Europe.

Unfortunately, in an emerging market returns often do not follow a normal distribution. As a result, making economic forecasts based on this type of mean-variance analysis much more problematic.

Emerging markets are often constantly changing. This makes it difficult to use historical data to make projections regarding future events such as growth rates or price increases.

Insufficient liquidity

Generally speaking, emerging markets are not as liquid as developed markets. This causes higher levels of price uncertainty and above-average broker fees. Investors who attempt to sell assets in such a market face a very real risk that their orders might be fulfilled at a much less favorable level than the current market price.

On top of that, brokers typically charge relatively high commissions since they have to go to more trouble to find counterparties for their clients’ orders. The net effect is that illiquid markets often do not allow investors to reap the benefits offered by fast transactions.

Insider trading restrictions not always enforced

Although the majority of emerging markets might claim that they strictly enforce legislation against insider trading, few have proven to be as diligent with prosecuting this practice as most developed countries.

Insider trading and different types of market manipulation make markets less efficient. This in turn results in equity prices deviating significantly from their intrinsic value. A system where these practices are rampant can become subject to massive speculation. It can also to a large extent become controlled by individuals who hold ‘inside’ information.

Problems with accessing financing

A banking system that is not well developed might prevent firms from accessing the necessary financing when they want to expand their businesses. The required rate of return on attained capital will often also be unnecessarily high. This increases the firm’s weighted average cost of capital.

A big concern with having such a high weighted average cost of capital is that there might only be a handful of projects with returns high enough to ensure a positive return on capital. This means that the number of profit-generating projects could be sharply reduced.

Relatively high political risk

The term political risk in this regard refers to the increased likelihood of adverse government decisions and actions. Where most developed economies follow a system of low government interference in the economy, businesses in emerging markets often face unexpected government intervention that could significantly impact the profitability of their investments.

Other factors that could increase the risk of investing in emerging markets include unexpected tax increases, war, changes in market policies, subsidies being removed, rampant inflation, and laws controlling the extraction of resources. Political instability can lead to civil war and a near-complete shutdown of industry, with workers either not able to or not willing to continue working.

Inadequate corporate governance

Positive stock returns typically go hand in with a strong culture of corporate governance. Emerging markets, however, often experience fairly weak systems of corporate governance. For example, the government or management have a bigger say in the running of the firm than shareholders.

When corporate takeovers are restricted by countries, there is not the same incentive for managers to perform if they want to keep their jobs. Corporate governance in emerging economies is typically not nearly as effective as their counterparts in developed economies. However, many emerging nations have recently shown significant improvement in this area to get more access to international financing.

Higher risk of bankruptcy

In many emerging markets fairly weak audit procedures and an inadequate system of checks and balances increase the threat of corporate bankruptcy. Although bankruptcies occur in all economies, the risks are higher outside the developed world. Within some emerging economies firms find it easier to ‘cook the books’ to portray a picture of profitability. The moment these practices are exposed, the firm experiences a sudden drop in its stock price and market value.

The reason why emerging markets have to pay relatively high interest rates on bonds is that they are typically regarded as being higher risk. The increased cost of debt further heightens the possibility of bankruptcy. Having said that, this asset class has left behind a significant part of its unstable past.

The risk of adverse foreign exchange rate movements

Foreign investments in, for example, bonds or stocks will normally produce returns in that country’s currency. Investors will consequently have no choice but to convert this back into their own country’s currency. A US citizen who wants to buy Brazilian stocks must, e.g., buy and sell these stocks using the Brazilian real.

This means that unexpected currency fluctuations might have a major impact on the profitability or not of an investment. An example is where the price of the local Brazilian stock increases by 7% but during the same period the Brazilian real depreciates by 12%. Instead of making a profit of 7%, the investor will make a net loss of 5% when selling the stocks and converting his money back to his local currency.

Pros of investing in emerging markets

If an investor exercises basic caution when investing in an emerging market, the benefits could, nevertheless, far outweigh the risks. Even though they are often volatile, the stocks with the highest returns and the fastest growth are often those from the fastest-growing emerging economies.

The secret to a successful investment in an emerging market is to never take unreasonable risks. ETFs (Exchange Traded Funds) are one of the best options if you want to invest in emerging economies. This will give your portfolio exposure to an entire country or a combination of emerging economies.

Apart from that, because of their international nature, quite a few American blue-chip stocks also offer a greater or lesser degree of exposure to emerging economies. An example that immediately comes to mind is that of Coca-Cola, where its revenue mix is a reflection of the fact that it remains popular not only in the US, but also in countries such as Japan, China, and South Africa.

Investing directly in such a stock, or in ETFs that invest in stocks like these as part of a balanced portfolio, can introduce emerging market growth potential to your portfolio while retaining a large amount of the stability for which developed economies have become renowned.

Investing in emerging markets: do the pros outweigh the cons?

In our opinion, investors should not allow risk to deter them from making potentially lucrative investments in emerging markets. The risk associated with individual emerging markets has dropped substantially over the last two decades. The average risk of investing in such an economy is now much closer to that of investing in a developed market.

Over the last 5 years, the annualized volatility of a balanced portfolio of developed market investments was only slightly lower than that of a similar portfolio in emerging markets. The latter can deliver crucial benefits for developed market investors when it comes to diversification. For investors who specialize in emerging markets, there are many benefits to a diversified portfolio. These would typically include stocks, mutual funds, and ETFs from a wide selection of emerging and developed economies.

How do investors purchase financial products for emerging markets?

Fortunately, there are numerous ways for investors to benefit from emerging markets. Popular options include stocks, mutual funds, and ETFs.

Stocks

US investors can buy individual emerging market stocks as foreign stocks that are being traded on overseas exchanges or as ADR (American Depositary Receipts) that are being traded on American stock exchanges. One of the best ways to explore opportunities is to use a stock screener such as FinViz. Search for stocks from emerging countries that are offering high dividend yields or being traded at discounted multiples.

Mutual funds

There are numerous mutual funds out there that concentrate on stocks from emerging economies. The downside is that the majority of them are actively managed, instead of being passive funds. Apart from that, their expense ratios might also be significantly higher than what is the case with ETFs (see below). You will have to decide for yourself whether factors, such as the manager’s track record, justify the relatively high fees.

The following two mutual funds are popular among investors who want to expose their portfolios to emerging markets:

– Brandes Emerging Markets Value Fund (BEMIX)
– T. Rowe Price Emerging Markets Discovery Stock Fund (PRIJX)

ETFs

Global ETFs and the cheapest and easiest way to invest in emerging economies. The reason is that they offer a whole portfolio within one particular security. Apart from that, they typically also charge lower fees than a comparable mutual fund.

Although there is a wide variety of emerging economy ETFs available, only a few of them concentrate on value investing. The majority of them are what is known as ‘smart beta funds’, which follow an alternative indexing approach.

A few examples of popular ETFs that are exposed to emerging markets include:
– iShares MSCI Emerging Markets Minimum Volatility (EEMV)
– FlexShares Morningstar Emerging Markets Factor Tilt (TLTE)

What are the alternatives to investing in emerging markets?

As we pointed out earlier, investing in emerging markets comes with its own unique risk/reward structure. While potential rewards are often much higher than what is typically offered by a stock market, mutual fund, or ETF investment in a developed economy, the risks are also higher.

This is of course not unique to emerging markets. There are many ‘alternative’ investments in the developed world that offer a similar risk/reward structure. Examples include IPOs, crowdfunding, hedge funds, private debt, private equity, venture capital, angel investment, art, antiques, and more recently also cryptocurrencies.

The underlying principles, however, remain the same. Ensure you have a balanced portfolio consisting of a mix of high risk/high reward and low risk/low reward investments. Investing the entire cash payout from your pension fund in Bitcoin could make you quickly rich. However, it can also make sure you spend your golden years on the street. The same is true if you invest all your savings in unknown emerging market firms. Do your homework, use common sense, and properly diversify your portfolio.