What are Emerging Markets?
Emerging markets refer to countries that experience considerable economic growth and have characteristics of a developed market but are still considered to be ‘developing’. The term was coined to replace the common label of ‘third world’ and presented these countries as being great investment opportunities of the future. Emerging markets typically progress by becoming more integrated with the global economy with increased foreign investment and development of financial and regulatory institutions. Some of the most notable emerging markets are China, India, Brazil, South Africa and Russia. Some index funds and ETFs still classify South Korea as an emerging market but more on that later.
What are the Risks of Investing in Emerging Markets?
Emerging markets have been a popular investment to some for many years, they offer a unique opportunity due to them being known as high risk high reward. Is this the case? Well emerging markets do tend to have high market volatility. Political instability and supply/ demand issues from natural disasters can cause a big swing in stock prices. Think India in the recent pandemic or the Chinese government turning against Jack Ma and Alibaba. A few more risks to be aware of are highlighted below.
- Increased chances of bankruptcy
- Poor corporate governance
- Lack of insider trading restrictions
- Foreign exchange rate risk
What Goes up Must Come Down
As you’re probably aware if you’ve read some of our other articles we’re big fans of Jack Bogle. One of Jack Bogle’s rules for investing success is mean reversion. The concept is simple, the stock price will move back towards its average over time. Take the last decade for example, the S&P 500 has averaged around 14% in the market which is a huge return. This has caused huge numbers of people to invest in the S&P 500 because this is bound to continue, right? The problem is, because returns have been so good and the price is so high its possible we’re above fair value of the S&P 500 and we could see reduced returns over the next decade. Conversely emerging markets have underperformed in comparison and many of these markets could be classed as ‘undervalued’.
Future Outlook of Emerging Markets
The rewards of investing in emerging markets might outweigh the risks. MSCI still classifies South Korea as an emerging market, its a world leader in tech with a solid democracy that has handled the coronavirus pandemic better than almost any other country. South Korea also had the best performing market this year with a gain of over 33% and if you invest in the South Korean economy you’re still getting well known companies like Samsung, Hyundai, Kia and LG.
China makes up the bulk of most emerging market index’s and it’s easy to see why. China has the second biggest economy in the world and is projected to overtake the US in about 10 years. The Chinese stock market is also considered to be largely undervalued at present so investing in emerging markets would mean getting some powerhouses on discount such as Tencent, Baidu, and Xiaomi. Even Charlie Munger has invested in Alibaba and he doesn’t exactly invest very often!
The average age of the population in emerging markets are typically much younger than their developed market counterparts, this would suggest a positive future outlook. Just take a look at some of Japans financial issues, over 30% of Japans population is over 60. With an aging population it’s hard to sustain economic growth and trends suggest other developed economies such as the US and the UK could be heading in the same direction.
How can you Invest in Emerging Markets?
Emerging market tracking Index funds and ETFs of course. These can minimise the risk of instability in individual countries or companies. We have mentioned out favourite all world stock market funds here and emerging markets typically make up around 11% of the total fund. There are some specific emerging market funds out there, Vanguards FTSE Emerging Markets ETF and iShares core MSCI Emerging Markets ETF to name a few. It’s worth checking the cost of these funds and what countries they actually consider to be emerging markets, there are even ones that exclude China.
The phrase emerging markets may be a bit outdated as China and South Korea are already major economic players. Nonetheless, the countries pigeonholed into this category seem to have a positive future outlook, there are of course risks involved but this comes with the opportunity for a greater return on your investment. It may be wise to invest into emerging markets as a whole as opposed to an individual country or company to reduce risk. You can read more about emerging markets in Mark Mobius’ book here.
The views expressed in this post are the authors and should not be construed as financial advice
You can sign up to Freetrade on mobile devices using our affiliate code ‘david/caf1c45c‘ and receive a free share worth between £3 and £200.