Emerging markets have been one of the hottest investment areas since the early 2000s, with new funds and new ways to invest popping up all the time. While there is no doubt that huge gains await investors that can find the right emerging market investment at the right time, the risks involved are sometimes understated. (For more, check out What Is An Emerging Market Economy?)
TUTORIAL: Exchange-Traded Funds
When high-risk and high-reward walk in lock-step, you have to ask yourself whether you are willing to give up security for a piece of the action. In short, you have to decide if emerging market investing is for you. We'll look at the facts in this article and try to help you make an informed decision.
What Are Emerging Markets?
Simply put, emerging markets describes economies that are between the stages of "developing" and "developed." Much like a teenager who is between childhood and adulthood, the emerging market phase occurs when economies see their most rapid growth - as well as the greatest volatility.
From 2000-2011, emerging market economies have swelled to include Brazil, China, India, Russia – collectively known as the BRIC nations – as well as Vietnam, South Africa and many more depending on how tightly or loosely you define "emerging" as opposed to "developing." Generally speaking, investors and economists are looking for a sweet spot where the political and social growing pains have largely ended and the economic growth has just begun. As you've probably guessed, this is easier said than done.
Emerging Market Risks
What are the risks of investing in emerging markets? Being late and being wrong are two risks. (To help you understand the risk involved, read The Risks Of Investing In Emerging Markets.)
Missing the Train
Being late is the more common of the two risks. By now it is no secret that China is an emerging market that is becoming an economic powerhouse. Everyone is talking about China and the chances are good that – unless you are absolutely naked – you are wearing something made in China. Because China is so well-known, the chances are also good that much of the growth is already done. You can see this by looking at the SPDR S&P China ETF (NYSE:GXC).
The SPDR S&P China ETF invests in large Chinese companies and its rate of growth can be seen as a weathervane for the Chinese economy. Here are the returns up to the end of June 2011, courtesy of Google Finance, broken up by time period:
|6 Month Return||1 Year Return||5 Year Return|
The largest peak occurred in 2007, shortly after the fund was launched. It shot up a staggering 102% before falling back down due to pressure from the mortgage crisis.
So someone who bought in 2007 has seen excellent returns. Although, 46.27% is not 102%, it is still pretty amazing. The person who bought later in 2007 (right near that peak), however, is down over 20% if they held the ETF until June 2011. As you can see, the timing of your investment makes a lot of difference because the growth of emerging markets isn't steady, and there is no shortage of backsliding.
At various points within the 2007-2011 period, the China ETF was trading very low even though the overall five-year trend is up. If you bought in October 2008 – the depths of the financial meltdown – you would have had a gain of around 130% sitting in your portfolio by 2010.
In short, emerging markets can be very volatile, swinging up and down in sharp movements. This makes the timing of an investment very important. When everyone is talking about China, China is expensive. When everyone is selling China that may be the best time to buy. (To further illustrate the point of timing, see Trading Is Timing.)
Picking the Wrong Horse
The other risk is a little harder to quantify. Being wrong is a possibility investors face whether they buy stocks at home or abroad. However, emerging economies can carry some extra risk when it comes to being wrong. This is simply because the price swings are so much larger. The process of emerging into a developed economy isn't a one-way track. Countries can face political upheaval, natural disasters or a host of other events that will push them back years – costing enthusiastic investors who bought in on hope.
Russia, for example, has been alternating between an emerging market and developing economy since the 1990s. The scars of communism and some poor monetary management caused a massive debt default that ruined the ruble and made the country an investing wasteland for a number of years. However, Russia also sits on some of the most fertile and geologically interesting land outside of Canada. Oil is the big source of income now, but Russia should also have mineral deposits of a comparable size. So Russia can be seen as a bad investment area in one light and a smart one in another. The same goes for every emerging economy from Brazil to Turkey.
Why You Should Invest: The Rewards
If everything is so volatile and risky, why do people invest? Because the rewards can far outweigh the risks if some basic caution is exercised. Remember China's disappointing five-year return of merely 46.27%? Over the same period of time (May, 2007 - June, 2011) the Dow Jones – a weathervane of the American economy – returned 1.2%.
The same gap in returns shows up between emerging and developed economies all over the world. This doesn't mean that there aren't exceptions, but, on the whole, the most growth and the highest returning stocks are going to be found in the fastest growing economies.
Growth with Reasonable Risk
The secret to adding emerging market growth to your portfolio is to only take reasonable risks. You could make huge returns by piling your life savings into every Chinese stock on the TSE Venture, but the chances are good that you will have troubles sleeping at night whenever there is a riot in China or a private company seizure by the government.
Fortunately, there are better, safer ways to add emerging markets to your investing toolkit. ETFs are great for adding a whole country or combinations of countries, and many funds specialize in finding stocks of every size to fill an investor's portfolio.
Also, many U.S. blue chip companies offer a decent range of exposure to emerging markets simply because they are truly global. Coke is as popular in China as it is in Canada, the U.S. or Japan, and Coca Cola's revenue mix reflects that. So buying these stocks or funds that invest in these stocks can add emerging market exposure with a balance of developed market stability.
The Bottom Line
Emerging markets are risky, but the rewards they can create make them a worthy addition to any portfolio. The challenge for investors is to find ways to cash in on the growth without taking on an unreasonable amount of risk. (For more on emerging markets, read Equity Valuation In Emerging Markets.)