The Emerging Markets sector carries with it a lot of inherent risk and volatility and it is not surprising to find that many investors have no exposure whatsoever to it. Ideally therefore if you are going to either dip your toe in the water for the first time, or consider increasing your exposure to this sector, it certainly helps to do this at a favourable point in the cycle. Could now be such a time?
What are the Emerging Markets?
Essentially it is a collective term for those countries that have certain characteristics of a developed country but do not meet the standards/criteria to be classified as one. You could say therefore that they are countries that have the potential to be a developed country in the future. As way of example, in South America you have Brazil and Argentina, in Europe Greece and the Czech Republic, in Asia India, Indonesia, Korea and Thailand, etc. They share the following characteristics –
- Higher Economic growth. The IMF recently stated that the Emerging markets are experiencing GDP of approx. 4.7% p/a, compared to 2.4% p/a for more advanced countries.
- Low income per person. The best example here is China, which is the 2nd largest economy (and many would argue will be the largest soon enough) but has GDP per capita of just $9,600 (unlike $48,000 in the United States).
- They have a larger % of unlisted companies (possibly a high number of Government owned), and are transitioning away from the Agricultural sector, into manufacturing and possibly more into the service sector.
Why invest in them?
It’s all about growth potential. As these countries continue to become more productive, often utilising technology created by and enhanced by develop countries, economic growth should ensue. Additionally, these countries (again, think China) have a fast growing middle class sector, spending more money and driving growth further. Finally, they continue to restructure to improve infrastructure domestically and increase both imports and exports internationally. As the country continues to move from an agricultural focus to manufacturing and eventually services, and as the big companies in these countries expand it should mean more returns for investors.
Why are they risky?
Buying shares in companies in such countries can be risky, for a variety of reasons. For example, you may find that the shares are not as liquid as those in developed countries, combined with potentially higher transaction costs of buying/selling. There is a higher degree of political risk, for example potential changing of Government legislation in the country in question – trade barriers/tariffs, higher taxes, weaker legal rights and copyright laws, etc. Finally shareholders may have less protection and CEOs may not put their interests first or provide as much information as larger companies in developed countries. A key way to avoid all of the above risks is to use a fund manager to diversify across hundreds of companies in 20+ emerging market countries.
Why may now be a good time?
The last decade (post-GFC) has arguably been a great time to be investing in the sharemarket. However there are significant differences in performance when you compare countries against each other. At one end of the spectrum the United States has gone from strength to strength and if you had put $1 into their market at the depths of the GFC you would have over $4 today. Many other countries have faired well also and in Australia your $1 invested back in March 2009 would now be worth around $2.80. The Emerging markets however, generally speaking, have been very ordinary over the same period.
The following graph shows the difference between the US (as measured by the Dow Jones) in Orange and the Emerging markets (as measured by the MSCI Emerging Market index) in green over the last 5 years.
There is, of course, no guarantee what lies ahead for either index, but the Emerging Markets certainly looks as though it has a good potential for some upswing over the medium to long term.