Emerging Markets 101

With the first half of 2013 now closed, somewhat of a divergence has become apparent between the performance of developed and emerging market stocks. While emerging market stocks have been the top-performing asset class over the past 10 years, they are exposed to some unique risks that may cause it to perform differently than developed equity markets. In this month’s commentary, I will provide a brief overview of the emerging markets asset class and why it has a place in a well-diversified portfolio.

What defines a market as emerging?

Geographically, emerging markets comprise most of Africa, Eastern Europe, Latin America, Russia, the Middle East, and Asia (excluding Japan). Emerging market countries are those which have made enough progress in key areas such as macroeconomic and political stability, education, and global market integration to signal they are progressing towards becoming classified as a developed economy. This does not mean all countries labeled as emerging will eventually become developed, only that progress has been made to that end. Emerging market countries still have many issues to overcome before they can break out of the emerging stage and become developed economies.

While overall country market size and economic output are large factors in determining if a country meets the requirements to be classified as emerging, commercial index providers (e.g., MSCI, S&P, and FTSE) also examine each country’s investment environment to ensure that the market is accessible to foreign investors, meets market quality standards, and provides adequate liquidity for investors.

What makes emerging markets riskier than developed markets?

Because of the upside growth potential of emerging markets if they are able to successfully transition to developed economies, the downside risks associated with failure to realize this growth and, correspondingly, long-term expected returns are higher than those of developed markets. These higher expected returns come at the cost of much higher risk than their developed market counterparts. These risks are particularly high in areas such as the liquidity of an emerging market, its economic environment, and political situation.

Liquidity is a much larger concern in emerging markets because of the smaller size of the marketplaces in which companies are traded. Much of these liquidity issues are worsened by government policies that restrict foreign investment, limit the repatriation of assets invested in the country, and limit movement out of the local currency.

The economic environment in emerging market countries is often more fragile than that of developed countries. Emerging market countries typically lack the sector diversification that most developed countries have, often being concentrated in industries such as commodities, basic materials, services, and manufacturing. Because of this lack of economic diversification, emerging countries are often reliant on other countries to support their economy. This reliance can often lead to contagion, when a recession in one emerging country spreads to neighboring emerging countries.

Higher levels of corruption and lower levels of government transparency in emerging markets have resulted in a general lack of trust and confidence by market participants. Markets are often slow to react to positive policy actions that improve the infrastructure of the economy or open markets to foreign investors because of mixed results in the past. The possibility that policies, political leaders, or even entire governmental regimes may change in the future leaves emerging markets heavily exposed to the risks of political change.

While emerging markets have higher risk on a stand-alone basis, do they have a place in a well-diversified portfolio?

Currently, a large portion of global growth is coming from emerging markets, with year over year GDP growth averaging roughly 4% in the first quarter of 2013, compared to less than 1% in developed markets. Based on the current growth trajectory, as well as demographics of emerging markets, many economists predict that the BRIC economies (Brazil, Russia, India, and China) will be much larger than most of the current G7 (U.S., Japan, Germany, U.K., France, Italy, and Canada) in terms of GDP by the year 2050. While only time will tell if these forecasts come true, they indicate the potential for robust long-term returns. Furthermore, emerging markets have become too large a piece of the global market to be ignored by diversified global investors (currently 11% of the global stock market).

While the higher risks associated with emerging markets translate to greater volatility than other equity classes, the fact that they do not consistently perform in line with the rest of the portfolio means that they provide balance to the portfolio and create trading opportunities.

For disciplined investors, the relative underperformance of emerging markets thus far in 2013 offers an opportunity to rebalance, selling stronger performing developed stocks and buying stocks in emerging markets at attractive relative valuation levels.