Emerging markets are grabbing investors’ attention again as some people look for places to diversify their portfolios.
While the U.S. has the world’s largest economy, there are other countries and regions with economies that are growing at a much more rapid pace.
An emerging market is an economy that has experienced rapid economic growth but still has room to grow, meaning it has not reached its full economic potential like that of a developed economy.
The MSCI Emerging Markets Index represents 27 different emerging-market countries, which include Brazil, Chile, China, Colombia, Czech Republic, Egypt and Greece, to name a few. The index holds more than 1,300 assets of varying sector weights. China takes up almost 40% of the index, followed by Taiwan, South Korea, India and Brazil in terms of weightings.
The annualized return for the index since December 2000 is nearly 10%. While the pandemic has impacted domestic as well as international investments, emerging-market equities are up about 3.85% year to date and have one-year annualized returns of about 36%.
With concern among some investors that the U.S. stock market might be overvalued, there may be bargains in emerging-market stocks or spare room for companies in this market to grow.
“Emerging markets are selling at discounted valuation multiples to the U.S. markets, but perhaps have a short-run benefit tied to global growth coming out of the pandemic,” says Jeremy Schwartz, executive vice president and global head of research at WisdomTree Asset Management.
Schwartz says getting faster growth at a discount to the U.S. is a positive combination. While emerging markets are not immune to risks, vaccine rollouts, steady economic rebounds and low interest rates may prove to be appealing tailwinds for emerging-market equities this year:
— Risks of investing in emerging markets.
— Benefits of investing in emerging markets.
— Emerging-market opportunities.
What Are the Risks of Investing in Emerging Markets
Investors are not on the ground in an emerging-market country to get a first-hand look at what is happening.
This may raise issues of transparency, where it can be difficult to find official documentation related to a company’s financials or initiatives. Quality and reliable company information may prove challenging to uncover as regulatory public reporting requirements are not as robust in emerging-market countries in comparison to those of the U.S.
Compared with publicly traded companies in the U.S., which require public filings by the Securities and Exchange Commission, this inaccessibility can be a challenge for investors looking to do thorough analysis and due diligence on a prospective international investment.
Political risk is also a reality in an emerging-market economy. Unstable leadership can result in economic consequences that could negatively impact businesses in the country or region, which may result in lower-than-expected returns to shareholders. A blow to a company can be caused by the intermingling of politics and business. This can compromise a business’ reputation and transparency and result in shareholders losing faith in corporate governance.
A country’s currency is tied to the performance of the economy.
“Currency risk is the most critical difference between investing domestically and in emerging markets,” says Eric Leve, chief investment officer at Bailard in San Mateo, California.
If an economy is growing, the currency can increase in value. The reverse can happen, too, in which case currency risk can arise. Depending on the value of the emerging-market currency, your investment returns can fluctuate.
“It is very rare for emerging markets to outperform U.S. equities when they don’t have a tailwind from currency strength,” Leve explains.
“Weakness for emerging-market currencies can result from fiscal or monetary mismanagement, weakening demand for the nation’s primary exports, political turmoil or rising interest rates in the U.S., which can impair many emerging markets’ abilities to support debt-financed growth,” he continues.
An emerging-market economy may also be presented with several challenges like insufficient resources or material goods, delaying output and hindering business growth. Other risks include flawed monetary policies or fiscal practices leading to a weak economy or inadequate regulatory practices. These economic risks could lead to a volatile investment portfolio.
What Are the Benefits of Investing in Emerging Markets
Investors looking for diversification can find it within emerging-market equities.
“In general, emerging-market equities bring a broader set of exposures as the opportunity set encompasses wildly differing geographies that in many cases have little to nothing in common with one another,” says Jared Leonard, investment specialist for international equity at Hartford Funds in Philadelphia.
That diversification, Leonard continues, provides exposure not only to differentiated businesses and geographies but also exposure to local economies that may not be as accessible to foreign firms.
Investment opportunities in emerging markets are attractive because these countries have growing economies. More people are moving out of poverty, resulting in a growing middle class. This new cohort of consumers is driving economic growth and could present opportunities for businesses to innovate and prosper.
Another significant benefit of investing in emerging markets is capturing the pace of economic growth. According to the International Monetary Fund’s January 2021 “World Economic Outlook” report, growth projections for emerging markets and developing economies in 2021 is 6.3%, compared with growth projections of advanced economies in 2021 of 4.3%.
Charlie Wilson, portfolio manager and managing director at Thornburg Investment Management in Santa Fe, New Mexico, explains the characteristics of emerging markets that make this market attractive for long-term growth.
Among the 27 emerging-market countries in the MSCI Emerging Markets Index, Wilson says these countries represent about 13% to 15% of global market capitalization. “But (they are) almost 50% of global gross domestic product, and about 60% of the global population lives in emerging markets, so it’s massively underrepresented in terms of the market cap relative to their contribution to the global economy,” he explains.
That said, there’s a lot of room for that market cap to grow.
Looking forward, Wilson says about 80% of the global middle class will live in emerging markets by the end of this decade.
“You are starting to see the rise of the emerging-markets consumer in India, Korea and China,” he says.
Furthermore, investment opportunities have improved, Wilson observes. “Four of the world’s top 10 companies by market cap live in emerging markets and this reflects that these opportunities to have substantial earnings power generated by the emerging markets consumer,” he says.
Emerging Market Opportunities
Experts encourage investors to do their research on the type of economy and political governance for any individual emerging-market economy.
“China is the second-largest economy in the world and it’s rebounding faster than some other markets,” says Harry Broadman, managing director and chair of the emerging-markets practice at the Berkeley Research Group in the District of Columbia.
While there is a lot of growth in China, Broadman says there’s also a lot of risks since China is dominated by the state.
“If you have the state own all the major firms and if the state were to change policies that would have a striking effect,” he explains.
Retail investors can go about examining emerging-market investments by accessing a mutual fund’s prospectus. Look at the breakdown and weighting of each country and sector allocations. Here you can find fund managers’ expectations of the investment outcomes along with risks and growth opportunities.
Broadman’s advice to retail investors would be to look at particular regions when investing in emerging markets like Latin America, Asia or Europe.
“Narrowing down investments to a group of countries in a particular region will get you some degree of consistency at a regional level,” Broadman says. This way you can help eliminate the risks of having a country with a large weight that may influence the direction of fund performance.
Investors can turn to funds to gain exposure in emerging markets. One example: The Thornburg Developing World Fund (ticker: THDAX), with an annual total return of nearly 23% in 2020.
THDAX can account for its strong performance in part due to its focus on quality businesses in the emerging-market asset class. Wilson points to the fund’s focus on strong businesses that can navigate difficult periods successfully for the fund’s strong performance.
“We went stock by stock in our portfolio and reassessed the outlook for each company in an optimistic and negative scenario for each holding,” Wilson says. “This led us to shift capital out of emerging markets where we felt like the outlook was dim and unclear making it difficult to value those businesses into the market where we saw better clarity.”
Another emerging-market fund to consider is the VanEck Emerging Markets Fund ( EMRZX), with 89 holdings that include Tencent Holding, Alibaba Group Holding ( BABA) and HDFC Bank ( HDB) as its top three positions.
EMRZX is focused on small to large companies with growth potential in various sectors. China makes of about 38% of the index fund’s country weighting, followed by India and Taiwan. Some of the heavy-weighted sectors are consumer discretionary, financials and information technology, among many others. Year to date, the fund has returned about 5%, and it has a one-year total return of about 30%.
Emerging markets are budding economies with a lot of volatility. That said, investing in these countries comes with risks and rewards. Having access to a different set of countries can offer exposure for investors seeking higher yield, growth and diversification.
Since each MSCI EM country is growing at its own pace, identifying the outlook of this market can challenging. But experts say it has the potential to grow this year, much faster than developed markets.
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