Emerging Market Equities

Emerging market equities are a popular option for traders and investors, given their higher potential.

Known for its potential to offer higher returns compared to developed markets, the expected premium for investing in emerging versus developed equity markets is usually 1-3% per year.

In other words, if you put your money in EM equities, over the long-run you might expect to earn an extra 1-3% in annualized returns. Of course, given the long-duration nature of equities, it can also be above or below that.

At the same time, many of the risks historically associated with emerging markets have seen a secular decline.

Key Takeaways – Emerging Market Equities

• Emerging market equities offer higher potential returns compared to developed markets, with an expected premium of 1-3% per year.
• Positive influences in emerging markets include growth driven by industrialization and urbanization, growing integration with the global economy, and improved political stability and increasing tendencies toward democratic governance.
• Drawbacks to investing in emerging markets include higher volatility, susceptibility to political and economic instability, and a lack of transparency compared to developed markets.

Positive Influences in Emerging Markets

Growth in Emerging Markets

Emerging markets typically grow faster due to factors like increased industrialization, rapid urbanization, more “catching up” to do, and a rising middle class that drives demand for goods and services.

This rapid growth often translates into higher returns for equities in these markets compared to developed markets, where growth rates are slower and more mature, yielding potentially lower returns.

Integration with the Global Economy

One of the key reasons behind the allure of emerging markets is their growing integration with the global economy.

This provides these markets with access to new markets and resources and enhances their visibility.

Political Stability and Democratic Governance

A significant shift observed in the recent past is the rise in democratic governance and political stability in many emerging markets.

This change has led to a reduction in the risk of political instability, a historical concern for traders/investors considering these markets.

Some can rightly argue that democracy doesn’t align with the more neo-Confucian, top-down, cultures of some emerging countries (e.g., China, Vietnam).

And one-person, one-vote results in elections essentially make them popularity contests, and many votes are not necessarily based on the thoughtful considerations of candidates’ capabilities.

However, democracy does enforce compromise and consensus decision-making.

Moreover, it can make it easier to peacefully get rid of an ineffective ruler.

Sound Monetary Policies

Also, many emerging markets have run relatively solid monetary policies.

For example, in the post-Covid period, many developed markets lagged the inflation that came out of it believing it would be transitory.

This led their cash and bonds to have negative real interest rates, which can undermine a currency and create lingering inflation issues.

On the other hand, countries like Brazil ran monetary policy in accordance with the data to ensure a positive real return on the money and credit.

Some countries have historically had issues with the central bank being overly controlled by autocratic rulers.

Drawbacks to Emerging Markets

The drawbacks also help to account for the higher risk premiums associated with EM assets.

Volatility in Emerging Markets

Emerging markets can be more volatile than developed markets.

The reasons for this include:

• Limited regulatory oversight can lead to instability.
• Political risks and events occurring that aren’t discounted into market pricing can create sudden market swings.
• Emerging markets often lack liquidity, leading to higher price volatility.
• Currency fluctuations can introduce additional risk. When you put your money into assets denominated in a different currency, the total return is then asset + currency.
• Dependence on foreign investment can make these markets sensitive to global economic trends.
• Rapid growth can be accompanied by more erratic financial performance since it may be dependent on credit availability and foreign funds.
• Because emerging markets have lots of building to do and these projects can be so debt- and interest rate-sensitive, there tend to be large growth swings in their economies.

This volatility can result in both higher potential returns and increased risk.

Susceptibility to Political and Economic Instability

Emerging markets can also be more susceptible to political and economic instability.

These factors can impact investment and result in unexpected losses.

Let’s look at some categories and examples.

• Political unrest: The 2013 coup d’etat in Egypt destabilized its economy, impacting investments.
• Economic instability: Hyperinflation in Venezuela led to major losses for investors.
• Policy changes: Unexpected changes in India’s tax laws impacted foreign investors in 2019.
• Corruption: Brazil’s “Operation Car Wash” scandal in 2014 led to a significant market downturn.
• Trade disputes: China’s trade tensions with the US have introduced less investment certainty.
• Political violence: Sri Lankan protesters’ invasion of the president’s house in 2022 (and refusal to leave) showed that government regimes can be fragile and lead to abrupt changes.

Transparency Concerns

Another challenge that traders/investors often face in emerging markets is the lack of transparency compared to developed markets (e.g., accounting, regulatory, political orders/systems).

This issue can make it more difficult for investors to analyze companies and assess risks, thereby increasing the complexities of investment decisions.

We’ll look at examples of the various common issues.

These can of course also exist in developed markets, but there are more developed regulatory systems that make these less likely to occur in the same type of frequency.

Emerging Markets: A Matter of Risk-Reward

Despite the risks associated with investing in emerging markets, it’s all relative to risk.

One could consider how much to place in EM equities relative to their overall equities exposure.

One probably doesn’t want a portfolio overly biased to EM equities and would probably want more balance.

But many might consider 3-15% exposure depending on their goals, preferences, time horizon, risk tolerance, and so on.

FAQs – Emerging Market Equities

What are emerging market equities?

Emerging market equities refer to shares of companies that are located in countries classified as emerging markets.

These countries are typically characterized by rapid economic growth and industrialization, but can also carry higher risks than those found in developed markets.

These include nations in regions like Latin America, Africa, Eastern Europe, and parts of Asia.

Why should I consider investing in emerging market equities?

Investing in emerging market equities can provide several benefits.

First, they can offer potential high returns, typically with an expected premium of 1-3% per year over developed markets.

Second, due to their rapid economic growth, emerging markets present opportunities for significant capital appreciation.

Lastly, they provide portfolio diversification, as their performance is often less correlated relative to how developed markets are in relation to each other.

How have emerging markets changed over the years?

Emerging markets have grown rapidly and become a greater percentage of overall global GDP.

They have become more integrated with the global economy, providing them with access to new markets and resources.

Moreover, many have been undergoing political evolution, becoming more democratic and stable. This has reduced risks associated with political instability.

What are the risks associated with investing in emerging market equities?

Despite the potential for higher returns, emerging markets also come with a higher level of risk.

They are generally more volatile than developed markets. They are also more susceptible to political and economic instability.

Additionally, these markets tend to have less transparency, making it challenging to analyze companies and assess potential risks.

Have risks associated with emerging markets have declined?

Some of the risks traditionally associated with emerging markets have declined over the years.

Improved economic policies, increased political stability, and better integration with the global economy have all contributed to a reduction in risk.

How do emerging markets contribute to portfolio diversification?

Investing in emerging markets can help diversify a portfolio because the returns from these markets are often less correlated with those from developed markets.

This means when developed markets are underperforming, it can mean that some of that capital is going to emerging markets instead, and vice versa.

Therefore, having a mix of investments from both developed and emerging markets can reduce portfolio risk and potentially enhance returns.

As we’ve written before, capital circulates more than it’s destroyed, which is the central argument for diversifying.

How can I invest in emerging market equities?

Investing in emerging market equities can be done through various ways.

Direct investments can be made by purchasing shares of companies listed on the exchanges of emerging countries.

Alternatively, investors can use mutual funds, exchange-traded funds (ETFs), or American Depository Receipts (ADRs) that focus on emerging markets.

Some professional investors might find these options inadequate, as EM indices are often concentrated in financial companies and overly in certain countries.

As a result, they might prefer private equity investments.

It is recommended to seek advice from a financial advisor before making these investment decisions.

How can I mitigate the risks associated with investing in emerging market equities?

To mitigate the risks, traders/investors should consider diversifying their investments across various emerging markets rather than concentrating on a single country or region.

In addition, thorough research and understanding of the political and economic environment of these countries is necessary.

You could also consider investing through mutual funds or ETFs, which offer built-in diversification. Mutual funds are managed by professionals.

How does the transparency of emerging markets compare to developed markets?

Emerging markets often have less transparency than developed markets.

This lack of transparency can make it more difficult for investors to gather reliable information about companies, potentially leading to more investment risk.

However, the situation has been improving in many emerging markets, with increased adoption of international accounting standards and stronger regulatory oversight.

What impact does political and economic instability have on emerging market equities?

Political and economic instability can lead to significant volatility in emerging market equities.

This can occur due to various reasons such as changes in government policies, economic reforms, social unrest, or conflicts.

Such instability can negatively affect the business environment and economic growth, which can in turn impact the performance of markets.

However, as many emerging markets are becoming more stable and more democratically run, these risks have been falling to some degree over time.

Conclusion

Emerging markets can be a viable and attractive investment destination.

For investors seeking diversification and potential long-term growth, adding emerging markets to their portfolios could be a serious consideration.

While there are inherent risks, careful analysis, and strategic planning can help mitigate these while maximizing potential returns.