For many, the idea of investing in emerging markets conjures up the image of highly volatile speculative stocks, that may leave investors high and dry. That may be the case, in some circumstances, but done right, emerging market stocks can actually reduce the overall risk of your portfolio, relative to return.
The definition of what makes an emerging market is somewhat subjective. South Korea, for example, is an economy that some people describe as an emerging market, while others say it is developed.
Basically, emerging markets are countries that have, underdeveloped economies, that are maturing and are expected to have accelerated growth. Investors can expect to achieve higher returns from investing in these economies. However, the risks of investing in them is higher than developed economies.
So, how can it be that emerging market stocks have a higher level of risk, yet including them in your portfolio will bring down your overall risk level? In order to understand why this is the case, we need to review some principles of Modern Portfolio Theory.
Emerging markets have what is called a negative covariance with developed markets. Basically, what that means is that emerging markets and developed markets move in opposite directions of each other. Having both asset classes in your portfolio reduces the overall volatility of the portfolio. Therefore, the overall risk of your portfolio is reduced.
By reducing the overall level of volatility or standard deviation in your stock portfolio, you go out farther on what is called the Efficient Frontier. Your overall return is higher, relative to the risk you are taking.
The word that sums everything up here is diversification. You have a mix of stocks and bonds. Part of that mix should be in developed markets and some should be in emerging markets. If you are investing for the long haul, your overall return will be higher than your risk, relative to someone that eschews emerging market stocks. Of course, there are other asset classes that you should target, that will also bring you farther out on the efficient frontier, but for this article, we will concentrate on emerging markets.
As you might expect, there are a lot of different views about how much exposure you should have in emerging market stocks.
Emerging markets make up 50% of the worlds GDP, but they only account for 10% of the total stock market capitalization. The iShares MSCI ACWI Index ETF has an 8.61% allocation. The MSCI ACWI index is a widely followed broad measure of equities throughout the world. That would seem to be the ideal allocation, since this is the benchmark for so many total world funds.
I personally, believe that emerging markets will outperform developed markets over the next several years. Although a thorough analysis is beyond the scope of this article, the primary reason is that they tend to have higher populations and I believe that there will be a convergence of living standards throughout the world, that will play out over the next decade. Therefore, I would allocate a higher percentage than what is in the MSCI ACWI Index.
You may already have some exposure to emerging markets. If you own any large cap multi-nationals, odds are they are generating revenue in emerging markets. Ideally, you also want to be invested in companies that are domiciled in emerging markets too. There are Several ways to do so.
American Depository Receipts or ADRs, are shares of foreign companies, that trade on U.S.exchanges. Alibaba’s (BABA) stock is a an example of an ADR. It is a Chinese company, that trades on the New York Stock Exchange.
Buying ADRs is a good way to gain access to specific companies in various emerging markets. The bad thing about investing in ADRs is that you don’t get the full effect of investing in the country, since the shares are issued in U.S. dollars. For some people, this is good, since you effectively are hedging away any currency risk. On the other hand, you miss out on any gains in the currency in which the company invested in is domiciled.
An Exchange Traded Fund or ETF, holds shares of an underlying index and trades like a stock on an exchange. Buying an ETF is a great way to quickly get exposure to a particular asset class.
There are ETFs that will give you access to a broad array of stocks. The Vanguard Emerging Market ETF (VWO) invests in stocks in various emerging markets. There are also ETFs that track the underlying indexes of individual countries or even certain asset classes in those countries. The Guggenheim China Small Cap ETF (HAO), invests in small cap stocks in China, for example.
There are a lot of mutual funds that target emerging markets. You should do due diligence on any fund you decide to invest in. Researching websites such as Morningstar, will help you uncover well run funds.