It's probably the most-hyped investment term of the past decade, but what exactly are emerging markets and can they make you money? What Investment answers the questions you may have been afraid to ask.
The label ‘emerging markets’ refers primarily to a small group of countries whose stock markets are considered not quite mature enough to be included within the sphere of ‘developed’ markets like the UK, US and Australia.
The MSCI Emerging Market index lists 21 countries as ‘emerging’, ranging from powerhouses like the 'BRIC' countries (Brazil, Russia, India and China) to smaller nations like Colombia and Hungary.
From an investment perspective, many emerging market investment funds will also invest outside this strictly defined area, buying shares in companies listed in what are known as 'frontier markets'. Frontier markets include countries like Vietnam, Argentina, Nigeria and Kazahkstan, considered to be even less developed than emerging markets, and therefore even riskier.
Emerging markets as a whole are considered to be a high risk/high reward investment opportunity. There is the potential for very high returns in these markets, both because the countries themselves are generally growing at a faster rate than the developed world, but also because the stock markets, and the companies listed on them, are growing and maturing.
Risks of emerging markets
However, allied to that is the potential for bigger losses. First of all, companies in emerging markets generally don’t have the same standards of corporate governance as stocks in developed markets, meaning there is more chance of companies being run badly and going bankrupt.
Secondly, there are more political risks in emerging markets, whether it be from corruption, overt meddling in companies or even coups and civil wars.
Stock market returns are also more volatile, partly for the reasons above and partly because of the amount of foreign ownership of emerging market shares. Emerging markets are seen as a risky play. Therefore, in strained global macroeconomic situations (like now for instance), investors from developed countries will abandon their positions in emerging markets first. This causes disruptive volatility in emerging market indices.
Due to these factors, emerging market indices tend to rise faster than developed markets during periods of strong global market sentiment, and fall faster when that sentiment turns negative. Investment professionals sometimes refer to them as 'a geared play on global equities', because returns are magnified, whether positive or negative.
Accessing emerging market equities
Direct access to these foreign stock markets is very difficult for the private investor. Therefore, the best way to gain access to emerging markets is through investment funds or exchange-traded funds (ETFs).
There are both open-ended and closed-ended funds that invest in emerging markets, either with an investment remit that covers all of the markets or with a specialisation in, for instance, Latin America or Asia. Several fund management groups have a reputation for stellar emerging market performance, such as Aberdeen, First State and Franklin Templeton.
ETFs, and other passive tracker funds, are also available for those who wish to track an emerging market index (generally the MSCI Emerging Markets). However, passive strategies historically have not performed as well in emerging markets as they have in developed ones. This is partly because the levels of research and generally available information are lower in emerging than in developed markets, leaving more scope for active managers to use their knowledge advantage to pick undervalued stocks and avoid overvalued companies.
Remember that you can hold emerging market funds, investment trusts or ETFs inside a stocks and shares ISA.
Emerging market bonds
Investors who want to benefit from emerging market growth, but without the exposure to potentially volatile overseas stock markets, could consider an investment in an emerging market bond fund. The bonds issued by the governments of developing countries are riskier than those issued by the UK and US government, but not as risky as shares.
Emerging market bonds are becoming increasingly popular with investors looking for a higher income with a low level of volatility, especially since the yields on 'safe' government bonds have fallen so low.
Related investment guides
Frontier markets – emerging markets on speed