Emerging Market Investments

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Key Points

Characteristics of Emerging Markets

Asia: Profile of an Emerging Market

Emerging Market Capitalization

Lessons From Asia

Risks and Rewards of Emerging Market Investments

Points to Remember

The rapid development of the emerging stock markets, both in terms of size and activities, is one of the most exciting stories in today's financial markets. These relatively untapped markets promise potentially high long-term investment returns and opportunities to further diversify an investment portfolio.¹

Annual foreign direct investment in emerging markets totaled an estimated $478 billion in 2009, up from $7.5 billion in 1980, according to the United Nations Conference on Trade and Development. Most of this investment has gone to markets in Asia and Latin America, regions that have had rapid economic development over the past decade. In turn, this influx of investment capital has further fueled economic growth in these countries.

Characteristics of Emerging Markets

Emerging markets are those of lesser-developed countries, which are beginning to experience rapid economic growth and liberalization. Examples of emerging market countries include China, India, and Mexico. Generally, these countries are described by a growing population experiencing a substantial increase in living standards and income, rapid economic growth, and a relatively stable currency.

Often, emerging market countries impose strict limits on foreign investment in an attempt to limit foreign ownership of domestic companies. Investors may be prohibited from owning more than a fraction of any one company, and they may also be restricted from repatriating profits from investing activities.

Asia: Profile of an Emerging Market

The potential rewards -- and risks -- of emerging market investing can be readily seen from the experiences of investors in Asia from late 1997 to 1999.

A major collapse in emerging markets began with Asia in July 1997, when the Thai government was forced to dramatically devalue its currency, the baht, after failing to defend it in the face of a very large currency account deficit, foreign debt, and a government budget shortfall. The result ricocheted throughout Asia as currencies in the Philippines, Malaysia, and Indonesia came under attack from speculators. Meanwhile, financial panic would seep into emerging markets throughout the world, from Latin America to Russia, as financial difficulties surfaced in those nations as well. Despite measures including a "rescue package" directed at Thailand by the International Monetary Fund (IMF), and promises of dramatic economic reform from Indonesia's government, investor confidence failed to return to most emerging markets until 1999. That's when signs of economic recovery began to appear in some of the troubled emerging markets, while others were boosted by deals with the IMF to help improve financial and economic conditions.

Emerging Market Capitalization
Emerging Market Capitalizaton (in $ Billions)
1990		1995	2010
Brazil	16	148	709
Korea	111	182	718
Mexico	33	91	204
South Africa	138	280	352
Taiwan	101	187	638
Source: Standard & Poor's.

Lessons From Asia

After the Asia crisis, many investors now realize there's no "free lunch" on Wall Street -- the high return of emerging markets investing comes with high risk, and many factors can trigger trouble. For example, the Thai baht's collapse began with lack of regulation among Thailand's real estate companies, causing a host of financial problems for that nation's government. The banks of both South Korea and Indonesia were practicing unsound lending practices. And in Brazil, a growing federal budget triggered doubts by potential investors that the nation could ever repay its debts.

It's especially important to note that the fortunes of one nation can increasingly affect those of another, as trading ties become tighter between most nations. As one nation devalues its currency, others may be forced to do so in order to keep their exports competitive, as some nations did when Thailand devalued the baht.

When Asia's troubled economies cut their oil purchases, energy-producing nations such as Russia and Ecuador also suffered from falling petroleum revenue. Currency risk can present another risk factor for emerging market investors. As the currency exchange rate fluctuates, so does the value of your investment in U.S. dollar terms. Fortunately, many emerging countries have their local currencies pegged to the dollar, which can result in a relatively constant exchange rate.

Risks and Rewards of Emerging Market Investments

Emerging markets can be volatile; therefore, they are considered appropriate only for long-term investors with an investment time frame of 10 or more years.

With such high risk potential, why invest in emerging markets, which are the underlying support for any country's financial market? One possibility is that emerging economies have the potential to achieve high levels of economic growth. In 2010, for example, emerging economies cumulatively grew approximately 7% while developed economies grew approximately 2%, according to the International Monetary Fund. Consider also that emerging stock markets alone represent only 13% of the capitalization of the world's equity markets.²

Along with high potential returns, emerging markets also offer potential diversification benefits. Because these markets may not to move in tandem with those of developed countries, they may be rising while other markets are falling. Hence, they may help reduce the overall risk of a portfolio.

Based on these factors, long-term investors may want to consider allocating between 3% and 10% of their stock portfolio to emerging markets, depending on their investment goals and tolerance for risk.³

How to Invest in Emerging Markets

Be aware that emerging markets in general tend to be volatile, sometimes even when no serious problem presents itself in a specific market. Investors in emerging markets are therefore advised to potentially reduce risk through diversification among many different markets, and to maintain a long-term view.

Probably the best way an individual can efficiently invest in emerging markets is through a mutual fund. Emerging market funds concentrate on investments in these markets around the world or in a specific country or region. Some global and international funds may also hold a small percentage of their portfolio in emerging markets.

Also keep in mind that some funds that invest in stocks of emerging market companies may also invest in bonds issued in that country. In general, these funds may contain a greater mix of different types of securities than a domestic fund.

Mutual funds offer the advantage of diversification and professional management. Because emerging market investment management may require extensive and expensive on-site company research, annual fund management expenses associated with these investments may be higher than for other types of mutual funds.

Points to Remember

1. Emerging market investments can offer higher potential returns to long-term investors.
2. Allocating 3% to 10% of your stock portfolio to emerging markets may help add a degree of diversification.³
3. Emerging market investments entail higher political and liquidity risks than domestic investments and, as such, may be more volatile.
4. Currency risks also affect emerging market investments. If the value of the dollar declines against the currency of the emerging market country, your return will be lower. The currencies of some emerging market countries are pegged to the dollar and usually do not fluctuate wildly.
5. Risk can be reduced by holding emerging market investments among different countries and regions of the world.

¹Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Past performance does not guarantee future results.

²Source: S&P Global Broad Market Index, December 31, 2010.

³These allocations are presented only as examples and are not intended as investment advice. Please consult a financial advisor if you have questions about these examples and how they relate to your own financial situation. The investor profile is hypothetical.

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© 2011 McGraw-Hill Financial Communications. All rights reserved.

July 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Troy Jones, a local member of FPA.