By Daniel Archibald | CFA
Diversifying a portfolio into countries where markets and rule of law is still developing can have its advantages and disadvantages. On the plus side, opportunities to find undervalued companies, or find industries that are likely to grow at a high rate, can be be more common than what might be found in the more developed markets. However, loss of capital due to political or legislative changes, can also be a more common feature of investing into emerging markets.
What are Emerging Markets?
Generally emerging markets are those regions and countries in which financial and capital systems are somewhat young, usually in poorer areas where industrialisation and modernisation are still taking hold, or where there still exists a level of social and political instability. Equity and bond markets in these countries are smaller and less liquid than their fully-developed counterparts, and may have restrictions on foreign investments. Currently, the major countries that fit this bill are the BRICs - Brazil, Russia, India and China, but other countries such as South Korea, Mexico, Indonesia, Philippines, South Africa and Turkey are also form part of this asset class. However, this does not include even smaller, "frontier" markets, such as Vietnam, Argentina, Estonia and Sri Lanka.
Why Include Emerging Markets?
When considering an investment into equities in general, investors are looking for higher long-term returns, those that can be attributed to overall economic growth and also to the entrepreneurial spirit for innovation and profit seeking. At the end of the day, shareholders invest so as to receive a share of profits, and can get great rewards from companies that can grow their earnings overtime. However, finding such companies at a reasonable price can be quite difficult in heavily researched markets, such as the US or Australian stock markets. Thus, opportunities for finding underappreciated companies, industries or countries can be easier within the emerging markets.
Also, investment returns and overall economic growth are likely to be higher in many of the less-developed markets. This may be due to better overall demographics (younger populations), benefits of urbanisation (higher value production) or deregulation (greater amount of capital freedoms).
How to Invest in Emerging Markets?
Of course, there are risks aplenty when stepping into this end of global equities, and so going about it the right way can be very important. Diversification across companies and countries can help reduce the political and legislative risks of emerging markets, and utilising the skills and experience of long-term emerging market investors will likely help you to avoid many of the pitfalls of this asset class. Also, due to foreign investment restrictions, it might not be possible to invest directly as an individual, but in stead be appropriate to invest through a registered fund manager.
Just as equities in general provide are likely to provide superior long-term returns over other asset classes, so too can emerging market equities help your portfolio to out perform. And considering that the size of emerging markets (particularly China and India) is expected to race past their developed market counterparts, thinking about larger allocations to emerging markets sooner, rather than later, might be a good idea.