Funds Investing in Emerging Markets What Is an Emerging Market? An emerging market is the stock market of a developing country, a country evolving from an agricultural or socialist economy to an industrial free market. Emerging stock markets exist in about two dozen countries, although that number changes frequently. Some countries leave the list of emerging markets as their economies mature; others are added as they open stock markets and begin developing capitalist systems. For example, in 1997 Portugal was dropped from an index that tracks the stock prices of developing markets, whereas the Czech Republic, Hungary, and Poland were added to the index. The primary investment appeal of emerging markets has been the high rate of economic growth in some developing countries in recent years, combined, in some cases, with stock valuations that appear reasonable in comparison with more mature stock markets. Rapid economic growth has helped many local companies to prosper, leading to rising stock prices. As Figure 1 shows, some experts predict that over the next few years certain developing economies will grow faster than some of the more mature economies. At times, price/earnings ratios in emerging markets have been lower than those in some more established stock markets. Why Invest in Emerging Markets? There are two main reasons to invest in the world's emerging markets. First is the potential for higher returns by investing in faster-growing, higher-risk markets. The second (and probably much more important) reason is broader diversification. Each of these reasons deserves careful consideration by prospective investors. Potentially Higher Returns Over time, some emerging markets have provided higher investment returns than the stock markets of developed nations, and many economists expect that to continue. Those higher returns reflect the greater potential for economic growth in developing countries, which should translate into higher personal incomes and greater corporate profits. It is not unusual for a developing economy to grow 6% to 7% in a year, far faster than the 2% to 3% that is typical for a healthy, developed economy. Those higher growth rates are not consistent for all emerging markets, however. In the mid-1990s, China enjoyed growth rates exceeding 10% a year, while some Latin American economies, such as Mexico's, shrank more than 6% in some years. Broader Portfolio Diversification Developed economies in Europe, the Pacific, and North America accounted for 94% of the world's stock market capitalization at year-end 1997. Figure 2 shows the stock market capitalization of the total world market and of emerging markets by geographical regions. Emerging market countries have widely varying economies, growth rates, and stages of development. Thus, their markets' movements historically have had a low correlation with market movements in developed economies, or even among themselves. In other words, when one market is rising, there is a good chance that another is falling. As a result, a small investment in emerging markets may offer investors an opportunity for increased diversification that has, in the past, led to lower overall portfolio volatility. What Are the Risks of Investing in Emerging Markets? Emerging markets generally involve much higher risks than those associated with developed stock markets. Investors preparing to commit capital to an emerging market should be aware of at least four primary risks: volatility, currency, illiquidity, and political risk. Some of these risks are common to all foreign investments; others are unique to emerging markets or higher in emerging markets. Volatility Risk If history serves as a guide, stock prices are likely to move up and down dramatically in emerging markets, especially in comparison with the stock markets of developed nations. In addition, emerging markets are immature, sometimes vulnerable to scandal, occasionally manipulated, and often lacking strong government supervision. Accounting, disclosure, trading, and settlement practices may at times seem overly complicated. Against this backdrop, many emerging markets have had to cope with unprecedented inflows, and outflows, of capital in recent years. The sudden movement of highly speculative, short-term capital has the potential, as seen in Mexico a few years ago, of taking with it much of a market's price support. Such sudden flights of capital, triggered by events in one emerging market, can spread instantly to other nations. When stock prices plummeted in Mexico and its currency collapsed in late 1994 and early 1995, the pain quickly spread to other emerging markets in Latin America. Currency Risk Movements in the world's currency markets can have a dramatic effect on returns earned abroad. High returns from rising stock prices could be turned into losses because of falling currencies, something that happened in Turkey in 1994. In that year, the Turkish stock market posted a strong one-year return of 31.5% as measured in Turkish lira, but a sharp decline in the value of the lira created a 50.5% loss after converting the investment into U.S. dollars. Figure 3 provides other examples of the impact of currency changes. Note how the 314.0% gain in Turkey in 1997 was reduced to only 118.1% after accounting for currency loss. Similarly, Indonesia's small loss of 2.3% became a 35.2% loss after taking the currency loss into account. When a developing nation's currency is devalued and its stock market declines, U.S. investors can also suffer exceptionally steep losses, as they did in Southeast Asia during 1997. In late 1997, nearly every Asian stock market was rocked by the actual and anticipated impacts of a currency crisis that first hit in Southeast Asia and spread to South Korea. Most reported returns from foreign stock markets take into consideration the effect of changes in currency rates, but it is rare for the currency changes to be noted separately from the stock price changes, as we have done in Figure 3. One of the primary causes of currency risk in emerging markets has been runaway inflation. Annual inflation rates of 1,000% or more are not without precedent. While there have been some notable successes in controlling inflation recently, for example, in Argentina and Chile—a potential resurgence of inflation remains a threat to currency stability. Illiquidity Risk Emerging markets are generally small, with fewer stocks listed and less trading than is common in the stock markets of developed countries. A developing country's entire market value, or capitalization, may be less than that of a single large U.S. company, and many companies in some markets are closely held family businesses. Shares of fewer than 200 companies trade in several markets (such as Turkey and Argentina), and total daily trading volume may reach only a few million shares. By comparison, more than 7,000 companies trade in the U.S. markets, and aggregate daily trading volume averages more than 1.3 billion shares.* The lower trading volume in emerging markets (their "illiquidity") means that investors may not be able to buy or sell shares at a fair price whenever they want to trade. In some cases, the financial markets have actually closed for short periods, such as in India where the Bombay Stock Exchange closed for three days in March 1995. Some countries also restrict foreign investments. In Taiwan, for example, foreigners are permitted to own only a specified class of shares, which may be available in limited quantities. In Chile, foreign investors must wait at least a year to withdraw capital from the market. *Sources: Wilshire Associates, Nasdaq Stock Market. Political Risk Many emerging markets are especially vulnerable to such political risks as coups, assassinations, or paralyzing power struggles. Some are governed by dictatorships whose succession plans are shrouded in uncertainty. Governments moving toward democracy may be grappling with long-standing political and social problems, and sudden retreats toward socialism could occur. Progress could also be stalled by economic reversals that have often gripped emerging economies. Equally important to consider is the risk of policy changes that could be unfavorable to external investors. These changes could include currency controls, taxation revisions, or, in a worst-case scenario, expropriation of foreigners' assets. Managing the Risks of Emerging Markets Investing Two effective strategies should be considered for reducing the high risks of investing in emerging markets. Both involve diversification. First, the stock markets of developing countries tend to act with a high degree of independence. Thus, investing in a diversified portfolio of Southeast Asian, Latin American, and smaller European markets reduces the risk relative to investing in any single emerging market. Second, emerging markets are highly volatile, so they are not for investors with a short-term outlook. More than a few speculators have been hurt by the volatility of emerging markets in recent years. As those markets soared in the early 1990s, speculators poured money into mutual funds that invest in developing countries on the basis of their recent performance. Unfortunately, many bought shares just as the emerging markets were peaking. When Mexico and some other emerging markets crashed in 1994, those speculators pulled out, having "bought high and sold low." The volatility that laid those speculators low, however, can work to the advantage of the disciplined, long-term investor. One possible strategy is to invest a fixed amount regularly over time (i.e., employ dollar-cost averaging) rather than invest a single or an occasional lump sum. In simple terms, the investor who buys shares at regular intervals, in consistent dollar amounts and over a long period of time, pays a lower average price per share than the average market price of the shares in question. This occurs because a constant dollar investment automatically purchases more shares when prices are low and fewer shares when prices are high. Of course, dollar-cost averaging does not ensure a profit nor protect against a loss in declining markets. Because dollar-cost averaging involves continually investing in securities regardless of fluctuations in their prices, investors should consider their ability and willingness to continue making those investments during market downturns. What Are the Costs of Investing in Emerging Markets? In addition to higher risks, investors should be aware of the higher costs of trading stocks in emerging markets. Brokerage commissions and custodial fees are substantially more expensive than they are in the developed markets of the United States and Europe. Several countries levy a tax based on a transaction's total value. Quoted returns on emerging markets often do not include these "real-world" costs, which are a significant drag on returns earned by investors. Moreover, thin trading activity often leads to higher "market impact" costs. Buyers of large blocks of shares, for instance, may have to "pay up" to complete a transaction, and sellers may receive a "marked-down" price. Overall transaction costs for buying a basket of emerging market stocks can be as high as 2%. Source: Morgan Stanley Capital International.