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By Maurits Pot

Emerging markets offer investors the potential for long term growth as well as an opportunity to diversify their investments. Companies operating in emerging markets benefit as economies grow, and incomes and consumer spending rise. With young and growing populations, these economies have room to grow too.

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What are emerging economies?

Emerging economies are characterized by rising rates of economic growth, consumer spending, industrialization, and foreign trade. Emerging economies typically have large and younger populations too.

There is no precise definition of an emerging market and various institutions have slightly different criteria for classifying economies. A popular reference point is the MSCI emerging markets index which includes 25 countries.

Investors regard many of the countries in Asia, South America, the Middle East, and Africa, and some countries in Eastern Europe and the Middle East as emerging markets (EMs). Some less developed emerging economies are known as frontier markets – although there is no formal distinction between the two.

Why invest in emerging markets?

An emerging economy can benefit from a virtuous cycle as it grows. As more people join the workforce, consumer spending rises, investment increases and more jobs are created. Over time the middle class expands, incomes rise and the total level of spending increases. The cycle is further supported by ongoing infrastructure investment.

This virtuous cycle acts as a tailwind for companies operating in developing economies. This includes multinational companies from developed markets (DMs) like a Nike and Starbucks, as well as local companies in each market.

As investors we can invest in EM equities and bonds, with EM bonds typically offering higher yields than DM bonds.

The pros and cons of investing in emerging markets

EMs offer several opportunities and advantages to investors:

• EMs expose companies to a growing middle class and rising incomes and consumer spending.
• Companies in emerging economies often trade at lower valuations than companies in developed countries. This can lead to higher long-term returns.
• Some of the largest consumer markets are now in countries with emerging economies.
• EMs have younger populations which means the workforce expands rather than contracts over time.
• EMs offer new opportunities for diversification. Emerging and developed market securities tend to go through alternating periods of outperformance and underperformance. Investing in both can therefore reduce volatility for a portfolio.
• Emerging market bonds have higher yields than the bonds of developed countries.

Most of the disadvantages of emerging market investing is related to the risks. These are the key risks investors face:

• Political and economic risk: Political instability and economic factors can lead to capital flight from a country.
• Currency risk: EM currencies are more volatile due to the political and economic risks.
• Liquidity: In some markets, liquidity can be an issue, particularly for small companies.
• Transparency and information: Companies in some markets do not need to disclose as much information as investors would like. Moreover, information is not as readily available as it is in DMs.

Most of these risks can be managed with diversification and active risk and portfolio management.

What’s the best way to invest in EMs?

If you want to invest in emerging markets, you can invest directly, or indirectly via a fund.

Direct investments in equities

There are three types of shares to consider for EM exposure:

Multinational companies: EMs account for a growing proportion of revenue for companies like Coca Cola, Nike and Starbucks. If you invest in these companies a lot of future growth will come from EMs - however, it will be diluted with revenue from DMs.

Emerging market companies listed on international exchanges: Some of the largest emerging market companies are listed on exchanges like the NYSE. Examples include Alibaba (China), Infosys (India) and Vale (Brazil). These securities are easily accessible to investors, but represent of fraction of the emerging market universe.

Locally listed companies: To access the full universe of emerging market securities you will need to invest on local exchanges. This is possible, but often requires a separate trading account for each exchange. Some countries, including China and Saudi Arabia, place significant restrictions on foreign investors.

Global emerging market funds

Investors usually opt to invest in emerging economies via ETFs or mutual funds. This is a practical approach as there are well over 10,000 viable emerging market securities to choose from. Investing in a fund also removes the need to hold trading accounts in several countries.

Two of the largest EM ETFs are the Vanguard FTSE Emerging Markets ETF (US:VWO) and the iShares MSCI Emerging Markets ETF (US: EEM). These funds offer broad-based exposure to EMs, though they do tend to be heavily weighted to China and India. They also hold a large number of securities which may dilute performance. 

Regional emerging market funds

EM investments can also be focused on specific regions or types of economies.

Dawn Global’s CUBS ETF is a good example of an emerging market fund with a regional focus. This actively managed fund invests in companies in Bangladesh, Indonesia, Pakistan, the Philippines, and Vietnam. These countries are currently going through an accelerated phase of development and growth.

Similar funds focus on groups of countries like the BRICS (Brazil, Russia, India, China and South Africa), PIIGS Portugal, Greece, Spain, Italy and Ireland) and MINTs (Mexico, Indonesia, Nigeria, and Turkey).

Individual country funds

Likewise, you can invest in funds that invest in specific countries, and there are many of these available to investors. This approach is riskier as you will no longer be diversified across several countries.

Conclusion

Emerging market investments can generate strong returns over the long term. Not only do EMs experience higher growth rates than DMs, but they have more room to grow.  While there are more risks, these risks can be managed by diversifying and selecting appropriate investment vehicles. Volatility can also provide attractive entry points for investors.

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