How to invest in Emerging Markets (and why EM stocks can’t be ignored)
If you want to know how to invest in emerging markets, or want to know more about this dynamic asset class that has delivered exceptional returns for many long term investors, you’ve come to the right place.
Jump straight to a topic:
What are Emerging Markets?
Emerging markets, often referred to as EMs, are economies in developing countries that are experiencing rapid economic growth and industrialization. These countries are typically characterized by low per capita income, high population growth rates, and a high potential for economic growth.
“Emerging markets have huge potential for growth and represent an important opportunity for investors seeking high returns. These markets offer a diverse range of companies and sectors, many of which are currently undervalued, providing investors with attractive investment opportunities,” he says.
Investing in emerging markets can be attractive for investors seeking to diversify their portfolios and tap into their high-growth potential. However, it is important to note that investing in emerging markets can also come with higher risks compared to investing in developed markets.
Despite these risks, investing in emerging markets can offer potential rewards. Many emerging market economies have young and growing populations, increasing consumer demand, and a growing middle class.
Moreover, many emerging market countries have been implementing economic reforms and opening up their markets to foreign investors, creating a more business-friendly environment. This has led to increased foreign investment and has driven economic growth in many emerging markets.
What regions and stock markets are considered to be EM?
The definition of emerging markets can vary depending on the index provider or financial institution. However, some of the most widely recognized regions and stock markets considered emerging markets include Asia, Latin America, Africa, and Eastern Europe.
In 2020, emerging market stocks outperformed developed market stocks by more than 18%, according to MSCI Inc. Asia is home to some of the largest and most dynamic emerging markets, including China, India, and South Korea.
Latin America is another region that is considered an emerging market, as Brazil, Mexico, and Argentina are some of the largest economies here.
Africa is also becoming an increasingly important emerging market. While South Africa is the most developed economy on the continent, countries such as Nigeria, Kenya, and Egypt are also attracting attention from investors.
Finally, Eastern Europe is another region with several emerging markets, including Russia, Poland, and the Czech Republic.
How are EM markets defined?
The emerging market consumer sector is projected to grow by 5.6% annually through 2025, according to McKinsey & Company. Defining emerging markets can be challenging as there is no universally accepted definition. However, there are several factors that are commonly used to classify a country as an emerging market.
One of the most important factors is economic development. Emerging markets are typically countries that have lower per capita income and are in the process of transitioning from a developing to a developed economy. The International Monetary Fund (IMF) uses a country’s Gross Domestic Product (GDP) per capita as one of the key indicators to classify a country as an emerging market.
Another factor that is often considered is the level of economic freedom and political stability in a country. Countries with a stable political environment and a business-friendly regulatory framework are more likely to attract foreign investment and experience economic growth.
Other factors that can influence whether a country is considered an emerging market include its population size, demographic trends, and access to capital markets.
It is important to note that the classification of a country as an emerging market is not fixed and can change over time. Some countries that were previously considered emerging markets, such as South Korea and Taiwan, have now become developed economies, while others may remain in the emerging market category for decades.
The typical characteristics of emerging markets stocks
Investing in emerging markets can offer investors several unique investment and economic characteristics, including:
High Growth Potential: Emerging markets are often characterized by high levels of economic growth compared to developed markets. Many emerging market countries have young and growing populations, increasing consumer demand, and a growing middle class. This can lead to increased investment opportunities in sectors such as technology, healthcare, and consumer goods.
Diversification: Emerging markets offer investors the opportunity to diversify their portfolios and reduce overall risk by investing in markets that are not closely correlated with developed markets.
Attractive Valuations: Emerging market stocks may offer attractive valuations compared to developed market stocks, particularly when considering metrics such as price-to-earnings ratios and price-to-book ratios.
Currency Exposure: Investing in emerging markets can expose investors to currency risk. Emerging market currencies can be volatile and subject to sudden devaluations, which can negatively impact investment returns.
Emerging market debt: Investors can also invest in emerging market debt, which can offer higher yields compared to developed market debt. However, investing in emerging market debt also comes with higher risks, including default risk and currency risk.
How to invest in emerging markets
Investors have several options when it comes to investing in emerging markets. These include via ETFs, mutual funds, direct share investing, private equity, ADRs and GDRs, emerging market bonds, and foreign currency.
We explore each of these below.
Emerging Markets ETFs
These funds typically track a benchmark index of emerging market stocks or bonds, providing investors with a diversified portfolio of investments. ETFs are easy to trade and have low management fees, making them an attractive option for investors.
As of March 2023, the largest emerging market ETFs by assets under management are the iShares MSCI Emerging Markets ETF, the Vanguard FTSE Emerging Markets ETF, and the Schwab Emerging Markets Equity ETF. The market capitalization of the MSCI Emerging Markets Index was approximately $7.6 trillion as of February 2022.
Emerging Markets Mutual Funds
These funds are actively managed by investment professionals who select individual stocks or bonds based on their analysis of the market. However, mutual funds can be more expensive than ETFs due to higher management fees.
Direct Investing in EM Stocks through Online Brokers
This approach requires careful research and analysis of individual companies, as well as a thorough understanding of the local market and regulatory environment. Many online brokers now offer access to emerging market stocks, making it easier for individual investors to invest in these markets.
Private equity funds that focus on emerging markets can offer attractive returns, particularly for investors with a longer investment horizon. However, private equity investments are typically only available to accredited investors due to their high minimum investment amounts.
ADRs and GDRs
American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs) are certificates that represent ownership in a foreign company’s stock. ADRs and GDRs can offer investors exposure to emerging market stocks while trading on U.S. exchanges. However, ADRs and GDRs may have higher fees than directly investing in foreign stocks.
Several Indian companies, such as Infosys and Wipro, are listed on the NYSE. Similarly, Chinese stocks, including Nio, are also listed on the U.S. bourses as ADRs.
Emerging Market Bonds
Investing in emerging market debt can offer higher yields compared to developed market debt. However, investing in emerging market bonds can also come with higher risks, including default risk and currency risk.
Investing in foreign currency can be complex and requires a thorough understanding of exchange rates and currency markets.
Investors should consider working with a financial advisor specializing in emerging market investments to help guide their investment decisions.
Why invest in emerging markets?
There are several compelling reasons for investors to consider investing in emerging markets. Here are some of the key reasons:
Growth Potential: Typically, emerging markets such as India and China grow at a far higher pace compared to more developed Western economies. Despite a challenging macro-environment, India’s GDP is forecast to rise by more than 6% in 2023 while the U.S. economy might grow by less than 2% this year.
Diversification: Investing across geographies lowers overall investment risk and provides you with diversification. You get access to markets that are on the cusp of delivering steady and consistent returns over time.
Undervaluation: Emerging markets can offer opportunities to invest in undervalued companies that have the potential for long-term growth. The valuations of many emerging market companies are often lower than their counterparts in developed markets, making them attractive investments.
Access to Resources: Many emerging economies are rich in natural resources, such as oil, gas, and minerals. Investing in these markets can provide access to these resources and companies that extract them.
Increasing Globalization: As the world becomes more interconnected, emerging markets are playing an increasingly important role in global trade and investment. Investing in emerging markets can provide exposure to companies that are well-positioned to benefit from this trend.
Yield Enhancement: Emerging market debt can offer higher yields compared to developed market debt, providing a potential source of income for investors.
Some of the arguments for EM investing
There are several compelling arguments for investing in emerging markets, which are supported by a growing body of academic research. This potential for growth in EMs is driven by factors such as a growing middle class, increasing consumption, and favorable demographics. This can result in higher returns for investors over the long term.
Demographic Trends: Emerging markets are generally characterized by a younger population with a growing middle class. This demographic trend can result in increased demand for goods and services, providing investment opportunities for investors.
Increasing Globalization: Emerging markets are playing an increasingly important role in global trade and investment. Investing in emerging markets can provide exposure to companies that are well-positioned to benefit from this trend.
The outlook for emerging markets
The outlook for emerging markets (EMs) remains positive, despite the challenges posed by the COVID-19 pandemic and other geopolitical risks. As of March 2023, the five largest emerging market economies by GDP are China, India, Brazil, Russia, and Indonesia.
Carmen Reinhart, Chief Economist at the World Bank, says this about the future of EM investing. “Emerging markets have come a long way in the past few decades, and today they represent some of the most dynamic and resilient economies in the world. These markets offer investors a unique opportunity to gain exposure to some of the fastest-growing and most innovative companies on the planet.”
Here are some of the key factors driving the outlook for EM:
Economic Recovery: Emerging markets are expected to see a strong economic recovery in the coming years, driven by factors such as government stimulus measures, rising commodity prices, and a rebound in global trade.
Increasing Consumption: As emerging market populations grow wealthier, consumer spending is expected to increase significantly. This is likely to drive demand for a wide range of goods and services, providing attractive investment opportunities for investors.
Structural Reforms: Many emerging market governments are implementing structural reforms aimed at improving economic growth, attracting foreign investment, and reducing corruption. These reforms are expected to create a more stable and attractive investment environment for both domestic and foreign investors.
Technological Innovation: Emerging markets are increasingly becoming hubs for technological innovation, with a growing number of startups and technology firms. These firms are expected to drive growth and create new investment opportunities for investors.
Favorable Demographics: Emerging markets are characterized by a young, growing population, which is expected to provide a significant source of economic growth in the coming years.
Overall, the outlook for emerging markets remains positive, and these markets are likely to continue to play an important role in global economic growth and investment opportunities.