Investing in Emerging Markets: The potential and pitfalls
By Matt Neill
Edited by Jekaterina Drozdovica
08:51, 21 September 2021
Emerging market investments could present some of the most exciting and variable prospects for stock traders over the coming years.
While returns in developed stock markets are more predictable, emerging market stocks offer investors substantial growth potential in some of the world’s most rapidly evolving countries, including China, Brazil, Indonesia and Turkey. The Vanguard’s Emerging Markets Index Fund, which invests in emerging market companies, enjoyed a five-year return of 40%.
As seen on the chart above, however, Vanguard’s EM Index Fund has proven volatile since its inception and has not always provided consistent returns. It is also important for any investor to note the challenges and potential pitfalls that investing in emerging market shares can bring. These include differing regulatory regimes, political risks and international trade dynamics, all of which can drastically change the fortunes of a firm from one day to the next.
Emerging markets also carry a greater risk of more volatile currency movements. Additionally, they face more limited access to international capital markets and are exposed to the interest rates and money supply decisions made by developed nations’ central banks.
Over the past year, emerging market risk has increased substantially, particularly as many of these export-dependent countries have suffered the greatest economic damage as a result of the pandemic, with slow vaccination rates and ongoing political pressures in several nations curtailing growth.
With the rise of the coronavirus Delta variant dealing a blow to the sector’s economic recovery, and a notable slowdown in consumer spending and investment in the biggest of all developing markets, China, there remain plenty of hurdles for investors seeking out value stocks in emerging markets.
The International Monetary Fund (IMF) has warned that fault lines are developing in the ongoing rally from the pandemic based on vaccine access, and while the outlook for developed nations is becoming more positive, it recently lowered its growth expectations for emerging markets.
But now that the world is beginning to move past the virus - albeit tentatively - the outlook for emerging market investment may be brighter. Lazard Asset Management analysts said in a recent report that they believed that the second half of 2021 would offer more positive prospects for investors:
It’s worth remembering that analysts aren’t always correct, so you need to form your own opinion based on research.
When it comes to investing, there are two main ways to gain exposure to emerging market stock returns: either investing directly in companies listed on either domestic or foreign exchanges, or buying exchange traded funds which offer broad exposure to particular sectors, countries or emerging markets as a whole.
Key Emerging Market Stocks
Within emerging markets there are several companies that have emerged over the last few decades as market leaders which now command multi-billion dollar valuations and form a critical part of their respective industries. Below are the three largest emerging market companies by market capitalisation that every investor in this space should be familiar with:
Taiwan Semiconductor Co
As the world’s largest supplier of semiconductors, Taiwan Semiconductor Co is the largest emerging market stock, commanding a market capitalization of $545bn. Semiconductors are a critical component in many electronic products, including smartphones, televisions and high-tech sensors used in automotive manufacturing.
The firm has gone from strength to strength over the past year, as ‘stay at home’ messages prompted a surge in demand for products using their components. The semiconductor market as a whole has struggled to keep pace with this demand, leading to higher prices and supply chain shortages, which have affected deliveries of everything from Playstation 5 gaming consoles to new cars.
With annual revenues of around $47.7bn in 2020, Taiwan Semiconductor Co is strongly positioned for future growth, particularly as other nations are only now beginning to build their own capacity in this vital sector.
The second-largest emerging market stock by market cap, Tencent has recently endured a difficult period, as its stock has suffered drops of over 19% so far this year on the back of a Chinese government crackdown on several of its revenue streams, including gaming and social media.
As the creator of the ubiquitous WeChat app, the company has a core position in its domestic market and a growing presence abroad, but it remains at risk of regulatory actions as the authorities tackle the immense reach and power of tech companies in the country.
Another darling of Chinese stock investors is Alibaba. It has suffered from shifting attitudes back home in recent times but has been one of the biggest success stories in emerging markets for years.
Founded by Jack Ma back in the 1990s, the company has since gone on to become one of the largest e-commerce platforms in China. It has also expanded into financial services and other verticals, but is facing a potential breakup due to governmental restrictions and changes in domestic trading rules.
As with all individual stock investments, it is important to remember that the decisions of particular management teams as well as the effects of regulatory scrutiny pose heightened risks for investors, and positions should never be overexposed to any one particular firm.
Key Emerging Market ETFs
Exchange-Traded Funds (ETFs) are some of the most popular instruments used by investors to gain broad exposure to specific sectors and countries without having to pick individual stocks and the increased risk that entails. Below are the top three biggest emerging market ETFs by assets under management (AUM).
Vanguard FTSE Emerging Markets ETF
The Vanguard FTSE Emerging Markets ETF is the largest emerging market ETF in the world by assets under management, with $81.8bn worth of capital managed by the fund.
The fund is popular with investors due to its broad-based nature, with exposure across all major EM sectors and countries, as well as its low expense ratio of 0.10%.
iShares Core MSCI Emerging Markets ETF
Offered by global fund managers Blackrock, the iShares Core MSCI Emerging Markets ETF is a more recent version of the established iShares MSCI Emerging Markets ETF which was formed in 2012 and is aimed at long-term investors, with a lower expense ratio of 0.11%.
The fund offers similarly widespread exposure across emerging markets at a lower price than its predecessors, and also includes more small-cap stocks which are not included in other major funds.
iShares MSCI Emerging Markets ETF
Among the most popular ETFs offered in the market, the iShares MSCI Emerging Markets ETF is one of the world’s oldest emerging market ETFs, being originally offered by Blackrock back in 2003.
The fund is more geared towards large-cap stocks than its younger sibling and has a heavier weighting towards certain sectors along with a higher expense ratio of 0.70%.
Emerging market ETFs also pose risks of their own, such as exposure to general financial market conditions, tightening of funding conditions in developed markets, as well as global demand slumps and liquidity issues.
How to invest in emerging markets
Investors can access emerging market assets through specific equities listed on both domestic and foreign exchanges, as well as exchange-traded funds which offer broader exposure.
Why invest in emerging markets?
Emerging markets are likely to contain some of the biggest growth stories of the coming years, as the countries encompassed by them integrate into the global economy and move from developing to developed markets. It’s important to note that these investments also carry risks linked to local regulatory and company-specific factors among others. And while they may rise quickly, the volatility also means there can be sudden drops.
Are emerging markets a good investment?
Emerging markets can be a good investment if investors conduct the appropriate due diligence and primary research on the assets in which they wish to invest, while remaining aware of the risks involved. As always, the choice to invest depends on your portfolio, investment goals and attitude towards risk. You should never invest more than you can afford to lose.
What emerging markets should I invest in?
Emerging markets offer a wide choice for investors, from industrialised and more developed nations such as China and Korea, to commodity powerhouses like Brazil and Indonesia. Your choice will depend on your portfolio’s requirements.
Edited by Jekaterina Drozdovica
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