Emerging markets often seem to offer provide new investment opportunities, their elevated economic growth rates offering higher expected returns – not to mention the benefits of diversification. But there are a number of risks that potential investors should be aware of before planting seeds of their capital in one of these up-and-comers.

Foreign Exchange Rate Risk 

Foreign investments in stocks and bonds will typically produce returns in the local currency. As a result, investors will have to convert this local currency back into their domestic currency. An American who purchases a Brazilian stock in Brazil will have to buy and sell the security using the Brazilian real.

Therefore, currency fluctuations can impact the total return of the investment. If, for example, the local value of a held stock increased by 5%, but the real depreciated by 10%, the investor will experience a net loss in terms of total returns when selling and converting back to U.S. dollars. (See our tutorial on Forex Currencies for background.)

Non-Normal Distribution 

North American market returns arguably follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be valuated using the same type of mean-variance analysis. Also, because emerging markets are undergoing constant changes, it is almost impossible to utilize historical information in order to draw proper correlations between events and returns.

Lax Insider Trading Restrictions

Although most countries claim to enforce strict laws against insider trading, none has proved to be as rigorous as the U.S. in terms of prosecuting these practices. Insider trading and various forms of market manipulation introduce market inefficiencies, whereby equity prices will significantly deviate from their intrinsic value. Such a system can be subject to extreme speculation, and can also be heavily controlled by those holding privileged information.

Lack of Liquidity

Emerging markets are generally less liquid than those found in developed economies. This market imperfection results in higher broker fees and an increased level of price uncertainty. Investors who try to sell stocks in an illiquid market face substantial risks that their orders will not be filled at the current price, and the transactions will only go through at an unfavorable level.

Additionally, brokers will charge higher commissions, as they have to make more diligent efforts to find counterparties for trades. Illiquid markets prevent investors realizing the benefits of fast transactions.

Difficulty Raising Capital

A poorly developed banking system will prevent firms from having the access to financing that is required to grow their businesses. Attained capital will usually be issued at a high required rate of return, increasing the company's weighted average cost of capital (WACC). The major concern with having a high WACC is that fewer projects will produce a high enough return to yield a positive net present value. Therefore, financial systems found in developed nations do not allow companies to undertake a higher variety of profit-generating projects.

Poor Corporate Governance

A solid corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater voice in the firm than shareholders.

Furthermore, when countries have restrictions on corporate takeovers, management does not have the same level of incentive to perform in order to maintain job security. While corporate governance in the emerging markets has a long road to go before being considered fully effective by North American standards, many countries are showing improvements in this area in order to gain access to cheaper international financing.

Increased Chance of Bankruptcy

A poor system of checks and balances and weaker accounting audit procedures increase the chance of corporate bankruptcy. Of course, bankruptcy is common in every economy, but such risks are most common outside of the developed world. Within emerging markets, firms can more freely cook the books to give an extended picture of profitability. Once the corporation is exposed, it experiences a sudden drop in value.

Because emerging markets are viewed as being more risky, they have to issue bonds that pay higher interest rates. The increased debt burden further increases borrowing costs and strengthens the potential for bankruptcy. Still, this asset class has left much of its unstable past behind. (Investing In Emerging Market Debt has rewards to offer.)

Political Risk

Political risk refers to uncertainty regarding adverse government actions and decisions. Developed nations tend to follow a free market discipline of low government intervention, whereas emerging market businesses are often privatized upon demand. Some additional factors that contribute to political risk are: possibility of war, tax increases, loss of subsidy, change of market policy, inability to control inflation and laws regarding resource extraction. Major political instability can also result in civil war and a shutdown of industry, as workers either refuse or are no longer able to do their jobs.

The Bottom Line

Investing in emerging markets can produce substantial returns to one's portfolio. However, investors must be aware that all high returns must be judged within the risk-and-reward framework. The challenge for investors is to find ways to cash in on an emerging market's growth while avoiding exposure to its volatility and other drawbacks. To learn more about the pros and cons, see "Should You Invest in Emerging Markets?"

The aforementioned risks are some of the most prevalent that must be assessed prior to investing. Unfortunately, however, the premiums associated with these risks can often only be estimated, rather than determined on a concrete basis.

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