Investing in Emerging Markets

The term “emerging markets” is used to describe countries or regions with underdeveloped economies in the process of industrialization. Countries that fall into this category vary in size and are usually considered emerging because they have begun to open up their markets and “emerge” onto the global scene. These countries are usually experiencing rapid growth, and the companies based in those countries can be a source of potential investment for the prudent investor.

“BRIC” is an acronym for Brazil, Russia, India and China, and often used as a synonym for emerging markets. There is a growing number of single-country and regional exchange traded funds (ETFs) that typically offer passive exposure to countries. These are tradable on securities exchanges in the same manner as common stock. The iShares MSCI Emerging Markets Index (NYSE:EEM) tracks emerging stock markets in general. This index can be used to invest in a broad range of countries with large weightings toward Brazil and China, particularly in financial sectors. The iShares FTSE/Xinhua China 25 Index (NYSE:FXI) invests most of its assets in the 25 largest company stocks in China. The iShares MSCI Brazil Index (NYSE:EWZ) invests in large cap Brazilian stocks. The table below shows returns for these ETFs compared to the S&P 500. It is easy to see what would attract an investor to emerging markets. You should, however, look at how they acted when the world economy soured in 2008.

Total Returns (Including Dividends)

Showing their volatile nature, when the ETFs from China and Brazil fell farther, they also rebounded higher. Except for the more diversified emerging markets ETF, the group remains slightly below the S&P 500 in relation to the 2008 high price levels, as shown in the chart below.

% Currently Down from 2008 High (as of 8/31/10)

Because their markets are generally unstable, emerging markets offer an opportunity to investors who are looking to add some risk to their portfolios. Often, the bigger the risk, the bigger the reward, so emerging market investments have become a standard practice among investors aiming to diversify while adding risk.

Standard Deviation

Emerging markets also suffer from a lack of diversification, as they are often heavily reliant on commodities and financial institutions. The chart below compares three key sector’s weights in emerging market ETFs to their weight in the S&P 500.

Country risk is evident in the ratings on debt issued by a country. While these ratings are not on individual companies within the country, it does shed some light on the general economic strength, willingness and ability on the part of their respective governments to pay their debt. China’s rating is four levels below that of the United States according to the S&P and Moody’s rating agencies. Sovereign debt in Brazil, India, and Russia would not be considered investment grade debt, with ratings below BBB by S&P and below Baa1 by Moody’s. These are considered speculative grade bonds.

Soverign Debt Ratings

Lastly, volatility is at the root of the earlier note about how far the emerging markets fell. Standard deviation shows an investment’s weekly price movements relative to its long-term weekly average movement. Without complicating this too much, know that the lower the standard deviation, the lower the volatility. Using the standard deviation of returns on the iShares ETFs previously noted, you can see the significant difference between emerging market volatility and that of the S&P 500 (as measured by the S&P 500 SPDR symbol: SPY).

We recommend that investors, with a 10-year or longer investment horizon, should invest in developed international markets, but keep that exposure at or below 10%. We generally recommend a portfolio of international stocks tracking the performance of the MSCI EAFE (European, Australasian and Far East) Index. If you are interested in investing in emerging markets, we suggest an ETF over individual stocks. That said, we feel emerging market exposure should be a small part of the international portion of your total portfolio.

Using emerging markets investments to diversify your portfolio may add to overall performance in good economic times, but it also adds to portfolio volatility. Investors never complain about the upside volatility, but bad news breaks periodically, and when it does, emerging market stocks can fall hard. We recommend you do not test your tolerance for loss by loading up on emerging market stocks.