Investment Guide for Beginners: Emerging Markets Explained

If you’re relatively new to investing or are preparing to start for the first time, there’s a good chance you will have come across the term ‘emerging markets’ either in the business and financial news or attached to investment products such as funds. Emerging markets are an interesting part of the investment landscape and sooner or later there is a good chance you will either invest in them directly, indirectly or have to make a decision on choosing to do so or not.

In this guide we will explain exactly what is being referred to when ‘emerging markets’ are mentioned, how the asset class fits within the wider investment landscape and its unique qualities.

Emerging Markets Defined

Emerging markets as a term and asset class covers one of the broadest categories in the investment landscape. Some now say so broad it has lost its relevance we’ll address that criticism later. ‘Emerging markets’, refers to a diverse group of nations that are not among the most economically developed nations with strongly regulated, highly capitalised and liquid financial markets. The latter are known as ‘developed’ markets and are generally considered to be those of North America, Western Europe and Australasia such as the USA, Canada, UK, Germany, Japan, and Australia.

Emerging markets are defined as countries which have well established to relatively well established equities markets and quickly growing economies but usually lower per capita income than developed markets. Their financial markets do not have the same history as those of ‘developed markets’, nor the same level of capital invested in them, individually. They are typically considered to include the large economies of Central and South America such as Mexico and Brazil, European markets such as Russia and even Spain and China, India, Hong Kong and Singapore in Asia.

The two most well know groups of emerging market countries are the BRICs (Brazil, Russia, India, China and the PIIGS, or GIPSI (Portugal, Italy, Ireland, Greece and Spain). You may well note ‘Ireland doesn’t have a lower per capita income than some nations considered as developed markets’. And you would be right. The emerging market group includes countries of very different stages of economic development. Russia, China, Brazil and India, for example, have huge economies and hugely wealthy individuals. But the average income per capita is far below that of, for example, Spain, Italy or Ireland. Hong Kong and Singapore are among the most expensive metropolises in the world and have the relatively high average income levels to match - the equivalent of an average of $60,000 and $80,000 calculated by purchasing power parity.

If it seems a confusingly random way to group nations together that is because it is. Countries that would be considered ‘developed’ by most economic metrics can be grouped into the emerging market classification just because they don’t have a big stock exchange, like Ireland, or because they don’t have a long history of a stock exchange with large numbers of big companies or with a smaller average company size by market capitalisation, like Spain and Italy. Others, like Hong Kong and Singapore, are simply home to many companies based in and deriving much of their income from still developing economic regions, such as South East Asia and China.

There is yet a third classification of markets below ‘emerging’ – frontier markets. Index compiler MSCI includes companies listed in 29 different countries in its frontier markets index and including Estonia, Slovenia, Romania, Serbia and Croatia from Europe along with nations as diverse as Argentina, Kazakhstan, Sri Lanka, Nigeria, Mali, Vietnam and Kuwait. Again, you will note that some of those ‘frontier markets’ would ordinarily be considered more economically developed than others in the ‘emerging’ group. Others would certainly be considered developing nations in a broader political and economic sense. Within financial markets they are grouped together on the basis that they have comparatively small stock exchanges that have not traditionally attracted significant international capital.

In conclusion, there is no completely objective methodology for defining developed, emerging and frontier markets. Different index compilers and financial market participants place different countries in different groups. South Korea, for example, is considered a developed market by some and an emerging market by others.

Many analysts believe the ‘emerging markets’ classification is one that has outgrown relevance as the countries included in the group have developed along diverging paths. Quoted in the Financial Times, Investec strategist Michael Power commented:

“The term today embraces big and small, developed and under-developed, industrialised and agrarian, manufacturing and commodity-based, rich and poor, deficit runners and surplus runners, and I could go on.”

Are Emerging Markets Still Relevant as an Investment Asset Class?

Given that the differences between emerging markets now clearly outweigh their similarities, does the classification still hold any relevance to you as an investor? And if so, how?

The fact is, whether or not emerging markets should still exist as a grouped asset class, it does. That in itself gives relevance and means it’s important to have some understanding of the term as an investor. There is well over $10 trillion of global capital invested in the ‘emerging markets’ asset class through passive indices. Index builders such as MSCI are followed by massive volumes of institutional investor capital so their emerging markets index is hugely influential. Pension funds invested in emerging markets are also very popular in the UK. The below is a table of the 10 most popular pension funds among clients of Hargreaves Landsdown, the UK’s most popular online investment platform. Only 2 do not include emerging markets in their asset allocation:

Source: Hargreaves Lansdown

The ‘emerging’ world economies have now overtaken the ‘developed’ economies in their contribution to total global GDP. They also have greater foreign currency reserves, built up over years of trade surpluses compared to the trade deficits most of the developed world has every year. In fact, the currency reserves held be ‘emerging’ economies are now around double those of ‘developed’ economies. This means emerging markets are now bankrolling the debt of the developed.

China is the most glaring example of the struggle around the ‘emerging economy’ tag. On Purchasing Power Parity (PPP) it is now the largest economy in the world, has a literacy rate of 96% and more high-speed railway tracks than the rest of the world combined. It’s stock market is also now the world’s second largest by market capitalisation, behind only the USA. Until now, concerns over governance and transparency have meant Chinese equities, other than those listed in Hong Kong, have not been included in major emerging markets indices despite the country opening up its capital markets to foreign investors. That changed last month as MSCI incorporated Chinese A-shares into its emerging markets index. For now, it is only a partial inclusion but if they are given their full weighting in the future China will dominate emerging markets. This may lead to the eventual break-up of the current classification of emerging markets with China, and possibly India, needing to be separated out if their weightings are not to completely dominate the class.

For now, though, the grouping still exists. If you invest in an index or fund with emerging markets exposure, it is important to understand how your money is being invested. If it’s via indices, it will be in a huge range of companies from China and India to Peru and Eastern Europe. Other funds invest in more specialised indices that focus on particular parts of the broad emerging markets class such as developing Asia. Others take an active management approach and cherry pick companies from emerging markets. This kind of fund costs more in fees than passive index trackers but makes it much easier to assess risk than broad-based indices that many analysts criticise as containing assets that range from ‘high quality’ to ‘garbage’.

The Strengths of Emerging Markets as an Investment Class

Despite what some consider to be the hotchpotch of quality in emerging markets, even EM passive indices have outperformed developed market peers over the past 15 years.

Source: Bloomberg

Faster growing economies, less correlated to developed financial markets, are a strength. While the global financial crisis also hit emerging market economies, they bounced back much more quickly than their developed counterparts as can be seen by the above graph of MSCI index performance. Much lower debt levels and rising GDP per capita are the main drivers. Despite higher growth rates, according to FMG Funds data, EM equities trade at a 25% price to earnings discount in comparison to DM equities.

There is also far less correlation between EM equities when compared to DM. This means that the economic strength and financial markets performance of different countries within the EM group do not follow the same patterns so tightly:

Source: FMG Funds/Bloomberg

The Risks of Investing in Emerging Markets as an Asset Class

As all investors should understand, the potential for higher gains goes hand in hand with accepting a higher level of risk. Emerging Markets equity investments are no different. While, as already covered, this varies significantly across countries grouped into EM, political risk is a more significant factor than is the case in DM equities. Political and economic volatility can halt growth and even put the legal certainty of private companies at risk.

Standards of corporate governance are perhaps the biggest risk in emerging markets. Regulators have less onerous requirements of listed companies. The result of this is occasional nasty surprises, with companies getting into trouble despite their financial reporting offering no clues to the possibility. Many a highly experienced investor has been burned after investing in an EM company only for a black hole in its accounting to suddenly appear from nowhere.

The final big risk associated with emerging markets is currency risk. The Argentinian peso’s woes has been a major story in finance over the past couple of months as its value plummeted. The Turkish lira and Mexican peso have also endured a rough spell. If the currency an equity holding is denominated in loses significant value, as is not unusual in emerging market economies, this will have a major impact on returns then converted back into pound sterling or another major developed markets currency such as the euro or dollar.

Conclusion

Overall, despite the risks and questionable and inconsistent definition of ‘emerging markets’, there are strong arguments why a well-diversified investment portfolio should have exposure to the asset class. Emerging markets are powering global economic growth, some are rising to become dominant international economies and they tend to offer better value than developed market equities.

Owning inexpensive assets with significant long term growth potential is the ideal for any investment strategy and that’s what EM assets represent. However, especially as a beginner investor, it is probably best advised to proceed with caution. Don’t overexpose your portfolio to EM and trying to pick individual EM equities yourself is probably not a good idea. Despite the drawbacks of EM indices mentioned, they are diversified enough that they have still performed very well compared to DM indices over the past decade or so despite the fact that they contain exposure to assets of varying quality. Doing some research on good managed funds with an EM focus or exposure is also an option.