Investing in Emerging Markets 101

Do These Riskier than Average Assets Belong in My Portfolio?

Investing in Emerging Markets 101
July 14, 2014

If you are looking for a potentially rapid growth investment, emerging market equities can provide some of the highest growth around – as well as some of the steepest losses. Should these volatile investments play a role in your portfolio? They certainly can – but through careful management and monitoring, like any higher-risk investment.

So, what is an emerging market, and how do I invest in one or more of them? Put simply, they are national economies in around the world that are moving from underdeveloped to more fully developed. They include larger, important economies like Brazil, India and Turkey, as well as smaller ones like Vietnam. Emerging economies are often found in former colonies of western European nations.

There are three main asset classes to choose from in emerging markets: stocks, bonds, and currency. And, within each class, you can purchase pooled investments or individual issues. We will discuss bond and currency investing in these markets in a future article. For now, however, let’s focus on stocks, also called equities.

As emerging economies are inherently less stable than developed ones, most equity investors reduce their risk profile by investing in mutual funds, rather than picking individual stocks. These pooled investments are managed by professionals with substantial emerging market experience. Some “index” mutual funds track marketplace performance in a basket of emerging markets. One popular fund of this type is the Morgan Stanley Capital Index (MSCI) Emerging Market Index. This index captures the collective performance of stocks from 21 countries, some of which are arguably past emerging these days (for example, China). The four largest of these are frequently called by their acronym BRIC (Brazil, Russia, India, and China).

Investments in emerging markets can take a variety of forms of stocks and/or bonds, and may or may not fall within the countries in the MSCI index. Therefore, it is extremely important to look at the holdings of any emerging market fund to assess the risk level.

Just as stocks can fall sharply in the short-term but outperform bonds in the long term, emerging markets can take a massive pummeling but tend to outperform domestic stocks in the long term. The past few years fall into the pummeling category.

Morningstar published data in late 2013 showing the annualized returns over different time horizons for the MSCI Emerging Market Index, the MSCI EAFE Index (composed of developed economies outside the US), and the S&P 500. Over the 1-year and 3-year horizons, Emerging Markets returned 3.7% and 0.7% respectively, while the EAFE returned 24.8% and 10.5% and the S&P 500 returned a staggering 30.3% and 17.7% respectively. With the S&P constantly charging into record territory, this should not surprise anyone.

However, over the 5-year horizon, the indices are all within several points of each other, and over a 10-year frame, the Emerging Markets returned 12.1%, compared to 7.6-7.7% for the other two indices.

This seems logical. If US stocks are tanking, investors are looking elsewhere for growth and capital is likely heading into overseas markets ¬– but because of the interconnected nature of the world economy, the correlations don't always follow that simple logic. Right now, the S&P 500 is still bumping into record territory, but the MCSI Emerging Market Index has increased by 10% within the past three months.

If you would like to try your hand at investing in emerging markets, remember these three tips:

  • Stay in Portfolio Perspective – Your portfolio should already contain some mixture of higher growth equities as part of your overall strategy. Emerging Market Investments should fit into this category. Whether that ratio for you is high or low, do not be seduced by the potentially higher returns and deviate from your overall strategy.
  • Diversify – Unless you have a great deal of expertise and knowledge in one individual market, you are better off investing in a broader emerging market fund instead of in one particular country or field.
  • Do Your Research – Check into the philosophy, holdings, and past performance of any fund you wish to invest in. If you invest directly in foreign equity, check into the country's external factors – inflation rate, monetary policy and currency strength, growth forecasts, the political situation – as well as the particulars of the company and stock in which you wish to invest.

Are you up for a ride on the Emerging Market Rollercoaster? If so, then buy your ticket and come along for the ride. Just remember that on this rollercoaster, ticket prices vary by the minute.

Also, remember that moderation is the key – solid choices in emerging market funds held over the long term will provide longer-term growth even with the unnerving volatility. And, just like a real rollercoaster, if you overdo it, you are likely to be sick at the end.

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