Emerging markets are often characterized by a rapidly growing economy, a young and growing population, increased foreign investment, political instability, currency volatility and poor public infrastructure. As a group, emerging markets represent about 70% of the world’s population and make up approximately 25% of global equity market capitalization. While there are several widely used standards or benchmarks for emerging market equities, we focus on the MSCI Emerging Markets Index (MXEF) which is a market capitalization index that consists of indices in the following 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates. Emerging markets range from economic powerhouses like China, India and South Korea to deeply challenged markets like Brazil and to smaller economies like Chile, Hungary and Poland. As economies in transition, emerging markets gain increased visibility and political clout, which require the adoption of sound macroeconomic policies to include the privatization of state-owned businesses, providing efficient access for foreign investors to both credit and stock markets and a demonstrated openness to fair international trade, free of onerous import regulations and tariffs.
The status of social programs in an emerging market can take on an increased importance when foreign investors are considering capital investment. The lack of programs to adequately address common social issues like poverty, health care and human rights is often a turning point in an investment decision. Many emerging markets lack certain public necessities and/or infrastructure such as good roads, public transportation systems, modern sanitary systems, current technology and communication capacity and even mail service. The most common institutional shortfall seen in emerging markets is often a poor, unfair or overburdened court system. Foreign investors demand that property rights be clearly defined and enforceable and when they look to the courts for contract dispute resolution expect the law to be administered fairly, completely and without unreasonable delay.
Do emerging markets offer investment opportunities for the typical investor? The answer is yes. The risks posed by emerging markets require that the investor be willing to accept greater stock price volatility and investment risk in return for the opportunity to realize large gains. The primary reason then for adding emerging markets to an allocation is to increase the portfolio’s expected return. In addition to improving risk-adjusted returns, emerging markets also provide diversification benefits as they are generally less correlated with developed markets like the United States and Europe. Correlation, as defined, “is a measure of how the prices of two types of investments move in relation to each other when exposed to the same market forces.” The correlation between US Large Cap stocks (S&P 500) and MXEF is about 0.60, which tells us that price movement of US large cap stocks and emerging market stocks is synchronized just 60% of the time. By their nature, emerging markets are not predictable and sometimes veer off course (political turmoil and natural disasters are possible causes) so patience and a longer term perspective are required. Emerging market equities are best suited to growth oriented portfolio allocations and should comprise approximately 25% of your international allocation or about 5% of your overall portfolio.