Foreign stocks generally fall into two categories: "developed market" and "emerging market." Each presents its own opportunities and risks for your portfolio. In part two of our series, we take a look at emerging markets and what they might offer your portfolio.
What is an Emerging Market?
Many of us have heard the news stories about emerging markets, generally having to do with a political conflict, currency crisis, or social uprising. These stories have led to the belief that these countries are some of the smallest, poorest, and most problem-ridden places in the world. However, this is not completely accurate.
An emerging market is defined by the International Finance Corporation (IFC) as a stock market that is in transition; increasing in size, activity, or level of sophistication. The term "emerging market" is applied to a country making an effort to change, and thereby improve, its economy to reach the same level of sophistication as nations defined as "developed."
An emerging market is further characterized by the IFC as meeting one of at least two criteria: it is located in a low- or middle-income economy as defined by the World Bank, and its investable market capitalization is low relative to its most recent Gross Domestic Product (GDP). The World Bank defines emerging markets as those that haven't reached the minimum Gross National Product (GNP) per capita of $9,656 associated with high-income (developed) economies.
Often, emerging markets are in the process of transforming from agrarian to industrialized market economies. Countries with emerging markets often have resources valuable to the global marketplace, and their equal participation in this arena is a desirable asset to the future world economy.
Source: US Department of
There are more than 120 emerging market economies in the world today. These figures would allow one to assume that the investment opportunities with such a large number of countries would be enormous. However, not all of these countries have stock markets. The World Bank estimated that between 1980 and 1992, the average annual growth rate in emerging markets was 3.1%. This number incorporates sub-Saharan Africa, which demonstrated a lesser growth rate than the emerging markets of Asia and the Pacific, which showed tremendous growth over the same period. Economic growth stems from improving educational and health standards, technological advances, and political reforms that lead to increasing productivity.
A few years ago, only 24 emerging market countries had stock markets. Today, there are more than 41. Some up-and-coming emerging market countries include Argentina, Botswana, Brazil, Chile, China, Columbia, Croatia, The Czech Republic, Ecuador, Egypt, Greece, Hungary, India, Indonesia, Israel, Jamaica, Jordan, Kenya, South Korea, Malaysia, Mexico, Morocco, Pakistan, Philippines, Poland, Russia, Slovak Republic, South Africa, Sri Lanka, Taiwan, Thailand, Turkey, Venezuela, and Zimbabwe. As the economies in these countries further develop, they will present more and more opportunities for international investors and become competitive in the global marketplace.
Isn't it risky to invest in emerging markets?
Investing in emerging markets gives you the opportunity to diversify your portfolio with an investment class that is only loosely correlated with developed markets. However, although emerging markets are affected when there are large market movements in developed countries, they do not always react in tandem. Investments in an emerging market have the potential to generate higher returns, due to the high volatility of these markets, but along with your potential for a higher return comes additional risk.
Emerging market stocks are expected to have large degrees of volatility. Their rapid growth can lead to large, short-term swings in equity prices. At the end of 1994 and beginning of 1995, the Mexican stock market was down considerably, currency values were plummeting, and there was a lot of speculation in the markets across Latin America. The Brazilian market returned 64.3% in 1994. Six months later, in 1995, Brazil was down 21%.
In addition, the fundamentals of an emerging market stock may look good, and there may be many reasons to believe the market is stable, but there can still be market surprises. The collapse of the Russian market in 1998 was a shock to most investors, who believed such a thing would never happen due to the country's importance to industrial nations. In contrast, Hungary and Poland previously struggled to surpass emerging market status and are now critical to the European Central Banking System. Both countries contemplate perhaps participating in the European Union at a later date.
Emerging market risk, which includes the possibility of political instability and changes in national policy, may not always be favorable to foreign investors. Currency markets can also affect returns. High returns from stock appreciation can turn into a loss due to unfavorable exchange rates. Also, the entire market capitalization of one emerging market country may be equivalent to that of a single large U.S. company. The volume of daily trading in this market is only a fraction of that in developed markets, making emerging market securities difficult to buy and sell; in addition to liquidity risk, orders may not consistently be filled all at once.
What can I expect to gain by investing in emerging markets?
Emerging market equity prices, driven by rapid growth, offer appealing potential growth opportunity for long-term investors. If sudden volatility makes you weary and provokes you into making a redemption order, then this is probably not the appropriate investment opportunity for you. The diversification these markets provide can actually reduce the amount of volatility in your overall portfolio, but emerging markets change quickly and along the way to developed nation status, despite the inherent growth potential, there will be some turbulence.
Emerging markets are a good source of asset diversification. They are inherently more volatile and less correlated with the other asset classes, making their market trends harder to anticipate. However, if you are tolerant of market fluctuations and you desire a bit more return over a long-term investment horizon, then an emerging market investment may be a viable option for you.
How much should I invest in emerging markets?
You should approach emerging markets investments with a certain amount of caution. It would be advisable to limit your investments in emerging markets to no more than 10% of your overall equity holdings.