Who's Afraid of an Emerging Market?

Who's Afraid of an Emerging Market?

Investors looking for big returns sometimes park their money in emerging markets.

The thinking is that since the economies of countries like India and China are growing so quickly, their financial markets must be as well. But the reality is a bit more complicated.

The economies of many emerging markets have shown impressive growth this year, which you would think would lead to equally impressive stock market gains. But this past year, on average, a fund that has a global portfolio of emerging markets has performed worse compared to a fund that holds U.S. investments. What gives?

Some Definitions

Before we dive in, let's clarify a few terms: Coined in 1981, the term “emerging market” refers to a country that is undergoing economic and social reforms that allow its economy to grow quickly. Emerging markets include everything from powerhouses like China, which looks more and more like a Western economy, to tiny countries like Tunisia in Africa. In both countries, foreign investment is flowing in, corruption is on the downswing, privatization of formerly government-owned firms is happening, and the middle class is growing.

Investing in emerging markets could take one of several routes. The riskiest is to buy stocks in companies based there. Less risky is selecting a mutual or index fund that will choose foreign stocks for you. Some funds focus on specific countries, but these are also fairly risky because they depend on one country—and you never know when military junta will take over, or massive flooding will shut down a capital city.

Even so, when we said that emerging market funds are performing poorly this year, we meant the less risky kind of funds, the ones that sample from emerging markets from almost all continents. So back to our main question: If emerging market economies are growing so quickly, why aren't emerging market funds following suit?

It's All About the Big Picture

The answer goes back to 2008 and 2009, when banks were failing here and in Europe, the stock market was plummeting and developed countries seemed to be on the brink of disaster. Investors were looking for other places to make money, and emerging markets looked good. So, money poured into countries such as China, Brazil and India, pumping up the prices of their stocks and funds, which in turn made those investments less of a good value.

Leaders of many of these countries then tried to discourage runaway speculation by tightening up the money supply and raising interest rates to slow the flood of money coming in. It largely worked, and stock market gains slowed.

By 2010, things had begun to turn around in the U.S., and the recession was declared officially over. Now, investors have largely decided that the U.S.'s underlying economy is sound, so our country is seen as the safest place to invest your money, especially in a year of high market volatility.

As investors began pulling their money out of foreign currency and putting it back into the dollar, the currencies in emerging markets began to lose value and inflation in those countries began to rise. At the same time, fears about the euro zone falling to pieces (read all about that here) have hurt emerging markets as well. A new deal to save Europe may spur the banks to loan less to emerging markets (a.k.a. deleveraging), particularly those in Eastern Europe.

As you can see, a number of factors are hurting confidence in emerging markets, pushing down the value of investments there.

The Pros and Cons of Emerging Markets

Emerging markets are a whole different animal from your usual funds. Here's what you need to know:

Pros: Growth Now and in the Long Term

In emerging markets, much of the population is moving into the middle class and gaining purchasing power, opening up more robust markets, and enticing foreign investment coming in. All of this means growth: These countries are projected to grow 6.4% this year, in contrast to 1.6% growth by advanced economies.

Additionally, emerging markets are expected to grow in the long term. They have younger populations just entering the workforce, as opposed to their baby-boomer Western counterparts. That means more people will be working and producing over the next couple of decades, instead of retiring and using government assistance.

Cons: Currency and Infrastructure

When talking about investing in other countries, there's an important factor to consider: currency. Let’s say you invest in two companies—one in the U.S. and one in India—and they perform identically. But if the U.S. dollar appreciates compared to the Indian rupee, your U.S. investment automatically becomes worth more (which is exactly what happened this year). On top of that, currencies in emerging markets are more volatile.

Speaking of volatility, emerging markets often lack the support structures that developed countries have: lack of checks against corruption, a dearth of formalized rules and standards, and little ability to deal with natural disasters or economic crises.

The Takeaway

Smart investors are all about diversification, which is traditionally done by investing in different industries and different-sized companies. Investing in emerging markets is another way of diversifying—just to different economies. While no one would invest exclusively in emerging markets unless they were a real gambler, investors willing to take on risk for possible high returns sometimes turn to emerging markets.

Image Courtesy of RobRyb/Flickr

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