U.S. stocks may be in the spotlight these days, but for emerging markets, 2017 was a banner year. The MSCI Emerging Markets index, which tracks 24 countries representing 10 percent of world market capitalization, generated cumulative gross returns of 37.75 percent in 2017. By comparison, the Standard & Poor’s 500 index returned 19.42 percent, according to Morningstar.
The surge in emerging market stocks reflects their strengthening fundamentals and a growing global economy. It’s a significant turnaround from the previous six years, when emerging markets suffered a slump characterized by spiraling profitability and poor earnings growth.
Last year’s performance was welcomed by emerging market investors, and the outlook for 2018 remains mostly positive. According to the latest Emerging Markets Investor Sentiment Survey by Columbia Threadneedle Investments, 57 percent of investment managers and advisors expressed optimism about emerging markets’ prospects. Forty-three percent said they planned to increase their emerging markets allocation over the next 12 months.
[See: 7 Emerging Market ETFs to Buy Now.]
Emerging markets are attracting more attention for three main reasons, says Scott Knapp, managing principal for CUNA Mutual Fiduciary Consultants in Madison, Wisconsin. “There’s greater awareness that the global economy is highly interconnected, and strong growth is more available in countries that are early in their life cycles,” Knapp says. “And after an impressive run in U.S. stock markets, international stocks look more reasonably priced by comparison.” Rising commodity prices also make emerging markets more attractive, “due to their abundance of natural resources and increasing demand from growing industrialized countries.”
Emerging markets are certainly hot now, but can they sustain their winning streak? A lot depends on where and how you invest, as you’ll need to balance your taste for risk with the value and growth potential that some regions still offer.
Be risk-aware. Emerging markets are inherently more volatile than other investments. They carry more political and currency risk relative to developed economies, and these risks “shouldn’t be underestimated by investors,” Knapp says. A currency or political crisis in an emerging economy could be devastating to stocks and bonds issued by affected governments and companies, with negative ripple effects for investors.
Higher volatility also can result from an emerging market country’s dependence on just one or two commodities, says Michael Sheldon, executive director and chief investment officer of RDM Financial Group at HighTower in Westport, Connecticut. Volatility can be compounded by unstable leadership, unstable or illiquid financial markets and high levels of inflation, all things investors need to be aware of.
“We always talk about risk versus reward,” says Mark Lloyd, owner and founder of The Lloyd Group in Suwanee, Georgia. “International stocks typically do well long term, but there is a risk.”
[See: 9 International ETFs That Are Off the Beaten Path.]
Your appetite for risk will determine how much to invest in emerging markets. Lloyd says if you have an aggressive portfolio, a 7 percent allocation to emerging markets might make sense, with that percentage divided into multiple funds encompassing large and small companies. An investor with a growth portfolio may want to reduce the emerging markets allocation to 5 percent, while investors with balanced portfolios might dedicate just 3 percent of assets.
Although emerging market volatility might scare off some investors entirely, diversification can help quell those fears. “Emerging markets have lower correlations with the U.S. than developed international markets and thus higher diversification benefits,” says Kostya Etus, portfolio manager at CLS Investments in Omaha, Nebraska. “While it’s true that individual emerging markets have unique political, financial and economic risks, they’re also highly uncorrelated with each other.”
How you choose to invest in emerging markets can have as much impact on your portfolio as the countries you invest in. Owning individual emerging market countries tends to be riskier. Gaining exposure to emerging markets through low-cost exchange-traded funds that include a wide cross section of countries and companies is the better option, Sheldon says. “If there are one or two countries that perform much better than other markets in a given year, you’ll miss out on that,” but if one or two countries perform poorly, the sting may be minimized.
Choose relevant benchmarks. Emerging markets can be unpredictable, and investors should gauge the temperature before diving in. A good starting point is comparing a region or country’s relative valuations versus the broad global equity market, Etus says.
For example, Asian emerging markets returned a whopping 43 percent in 2017, driven largely by China’s strong performance. “This has propped up the relative valuations for the region into about fairly valued territory,” Etus says. Conversely, Latin American and European emerging markets still look undervalued and may be positioned to outperform in 2018 and beyond. An emerging country like South Africa, on the other hand, “doesn’t have valuations or momentum on its side and investors may be better off avoiding it.”
Besides valuations, investors should also consider economic growth, corporate profits, monetary policies and overall performance of individual emerging markets when making investment decisions. Study their returns, says Scott McCormick, charted market technician and instructor for Online Trading Academy, a financial education website for investors. “My focus for opportunities would remain on markets that have proven they’ve performed before, and avoid those that aren’t as strong, with the idea that strength attracts more strength.
McCormick says investors can look to the MSCI Emerging Markets index to gauge performance, but should understand how the index is built. As of December 2017, seven of the top 10 constituent companies in the index were based in China. In the context of an index that’s heavily weighted toward Asian companies, investors would do well to “keep a close eye on the monetary policy coming from the Bank of China to see how aggressive they are in addressing any inflationary pressures that typically build as economies grow.”
[See: 9 ETFs to Capture China’s Red-Hot Growth.]
Lloyd cautions against chasing returns with emerging markets, advocating that investors buy and rebalance instead. As one sector goes up, you can use the gains to buy into other asset classes, ensuring more consistent performance over time. “Don’t buy and sell,” he says. “Have a strategy that’s designed to give you growth and manage the risk efficiently.”
More from U.S. News
The Fastest Ways to Lose All Your Money in the Stock Market
10 Ways to Buy International Small-Cap Stocks
2 Tips for Investing in Emerging Markets in 2018 originally appeared on usnews.com
