Emerging markets can bring opportunities for immense growth while diversifying your investment portfolio. However, they also come with their own set of risks. Here’s what you need to know before taking the plunge.
If you’ve been sniffing around for investable assets and markets, chances are you’ve heard of the term ‘emerging markets’ more than once. Indeed, in an age of globalisation, emerging markets are becoming more vital to the global economy.
Yet, there’s still a lot to learn about these markets — their prospects, risks and opportunities involved. If you’re thinking of venturing into them, here’s what you need to know.
What are emerging markets?
The term ‘emerging markets’ refers to countries or regions that are undergoing rapid economic growth, transitioning from a pre-industrial, low-income economy to a modern industrial one with a higher standard of living.
Though the classification used to qualify emerging markets varies, levels of income, quality of financial systems, and growth rates are all popular criteria. Some current examples of emerging market economies include India, Mexico, Russia, Pakistan, Saudi Arabia, China, and Brazil.
What countries are considered emerging markets?
At the time of writing, the IMF identifies a total of 40 countries as middle-income emerging markets. The four main ones are Brazil, Russia, India, and China (BRIC), while others include South Africa, Mexico, Pakistan, Colombia, Egypt, Saudi Arabia, Indonesia, Vietnam, and Turkey.
So, why should investors pay attention to emerging markets? Because of these mega-trends taking place there: population growth, ‘financialisation’ (i.e. greater use of consumer credit), digitalisation (i.e. greater use of the internet for services such as banking and shopping), and industrialisation.
All of these mean that emerging market equities have the potential to outperform developed market equities as long as the population continues to grow and innovation continues to expand in these emerging markets. In short, lots of room for economic growth and financial returns.
What are the pros of investing in emerging markets?
In investing, it never pays to put all your eggs in one basket. Diversification is a good way to mitigate your investment risks, and emerging markets offer new avenues of potential growth, possibly in up-and-rising industries.
High economic growth
Emerging market stocks may be notoriously volatile, but these countries tend to be rapidly industrialising and modernising, resulting in high growth rates if you can ride out that volatility over the long term. With high economic growth, emerging markets can offer higher expected returns.
Furthermore, volatility doesn’t always mean making a loss. Active investors who buy when stocks dip can enjoy the appreciation gain when they rise again. Emerging market stocks also tend to have more room to grow, providing enhanced growth potential over time. However, this is not a given and investors should do their due diligence and research on the economic trajectory and sociopolitical climate of a country before deciding to invest their funds there.
New investment opportunities
Emerging markets present new opportunities for hungry investors who have already entered developed markets a long time ago. They are new and exciting and hold lots of potential in terms of growth and diversification, and can be a good addition to your portfolio. You will also be entering a nascent market when prices are attractive and stand to gain by being at the forefront of a new market or industry that is just gaining momentum.
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What are the risks involved in investing in emerging markets?
Despite the potentially great benefits of investing in emerging markets, there are also risks that investors need to be aware of before pumping their capital into these up-and-coming markets.
Weaker corporate governance systems
Organisations with a solid corporate governance structure tend to produce positive stock returns, as compared to those with weaker corporate governance systems, where perhaps the government has a greater voice than shareholders. As emerging markets sometimes have weaker corporate governance systems, these companies are under the thumb of external stakeholders, which may limit their autonomy and affect their revenue-making decisions. In turn, that would affect your investments in those companies.
While most developed nations tend to follow a free-market model with low government intervention, emerging market businesses can sometimes be privatised on demand, potentially leading to changes in policies and protocols and greater instability in the financial climate.
Furthermore, political risk is the uncertainty caused by questionable government actions and poor decisions. Other factors contributing to it include the changes in economic policy, tax hikes, out-of-control inflation, availability of grants and subsidies, and more. Political instability and civic unrest can also lead to industry shutdowns as workers are unwilling or unable to work.
An inadequately developed banking system — as in the case of many emerging markets — can prevent companies from having access to financing that they require to grow their business. The attained capital may also be issued at a higher required rate of return, which increases the company's weighted average cost of capital (WACC). And since there are fewer projects that will produce a high enough return to offset the WACC, this means they may not yield a positive net present value, which in turn affects the profitability of an investment.
On top of that, as emerging markets are regarded as being riskier, they have to issue bonds that pay higher interest, which increases borrowing costs and the debt burden, and thus the potential for bankruptcy. There may be an inadequate system of checks and balances — or accounting audit procedures — which can further increase the chances of corporate bankruptcy.
Risks in foreign exchange rates
For bonds and stocks, foreign investments typically produce returns in the local currency. Investors would therefore have to convert this local currency back into their domestic currency. For instance, a Singaporean who purchases a Vietnamese stock would have to buy and sell using the Vietnamese dong, but calculate his returns in Sing dollar.
This means that currency fluctuations can impact your total returns on the investment. For example, if the local value of a stock increased by 10% but the dong depreciated by 15%, the investor will ultimately experience a net loss in total returns upon selling and converting back to SGD.
How To Invest in Emerging Markets
When considering investing in emerging markets, it’s imperative to first look at your overall objectives, which should include growth and diversification. Your portfolio should be well diversified and you also need to have a relatively high risk tolerance that helps you accept the volatility of emerging markets.
The easiest way to invest in emerging markets is through an exchange-traded fund (ETF) that’s designed to track the performance of top companies in these markets.
If you’re looking to buy global stocks, you can invest in an ETF that follows the MSCI Emerging Markets Index, which tracks mid-cap and large-cap stocks in 24 Emerging Markets (EM) countries.
Here’s a step-by-step guide to invest in an emerging market:
Step 1: Open a brokerage account
A brokerage account is needed for buying and selling investment products (e.g. equities, fixed-income products and other trading products) on the financial market. Here’s our guide on how to pick the best brokerage account for you.
Step 2: Determine your asset allocation
Decide how much emerging market stocks you want taking up your portfolio in relation to your existing assets. This decision would depend on your risk appetite, personal financial circumstances, time horizon, and other factors.
Step 3: Choose your investments
After pumping in the money you wish to invest, it’s time to pick your stocks. Do adequate research on the companies and countries you plan to invest in—this may include the country’s GDP, growth rate, and the health and trajectory of its primary companies.
Step 4: Purchase your investments
Once you’ve decided on your investment picks, you can then purchase it with the funds you’ve put into your brokerage account.
The world is your oyster, and opportunities abound when it comes to investing in emerging markets. These markets around the world are actively growing and industrialising, and the forward-looking, risk-taking investor can certainly take advantage of the tremendous growth of such markets by investing in stocks, bonds, ETFs or mutual funds. However, as with any form of investing, be sure to do your due diligence before pumping your funds in an emerging market.
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