What are emerging markets?

Emerging markets are developing economies, many of which are experiencing rapid growth and industrialization. These countries possess securities markets that are progressing toward, but have not yet reached, the standards of developed nations. Emerging markets typically have fewer and smaller publicly traded companies than developed markets. Securities markets there may have lower liquidity, less regulation, and weaker accounting standards than more mature markets such as the U.S., Japan, and many countries in Europe.

In recent years, emerging markets have attracted considerable attention from investors due to their rising shares of global economic output and stock market capitalization. Favorable demographics and high economic growth expectations have made emerging markets popular investments despite their unique risks, which will be discussed in more detail.

While there is no definitive classification system, investors generally consider much of Africa, Asia, Eastern Europe, Latin America, and the Middle East to be emerging markets. Four of the most prominent are the fast-growing "BRIC" economies: Brazil, Russia, India, and China. Investors sometimes add another layer by labeling countries as "frontier" markets, which consist of even smaller, less-advanced economies that may present high barriers to foreign investment or face significant political uncertainties—features that can add to their volatility.

Why invest outside of the U.S.?

Investing internationally helps diversify your portfolio. Although the U.S. is the world's largest economy, U.S. stocks make up less than half the world's total market capitalization. An investor holding only domestic stocks likely would miss out on opportunities elsewhere.

Although diversification cannot assure a profit or protect against loss in a declining market, spreading your portfolio across a number of countries can help you take advantage of a larger opportunity set and potentially reduce losses that occur in any single market. While one or more foreign markets may sometimes move in the same direction as U.S. stocks, performance leadership historically has oscillated between U.S. and foreign markets over longer periods.

Why consider emerging markets?

One benefit of allocating some of your portfolio to emerging markets is to help further diversify it. Diversification provides benefits when a portfolio's holdings do not move in lockstep. Although emerging markets stocks and bonds historically have been more volatile than U.S. equities and fixed income, exposure to these markets actually can decrease your portfolio's overall volatility when returns of individual holdings diverge. In recent years, correlations between global markets have increased (i.e., markets have moved together more frequently). Whether or not this trend continues, U.S. market returns historically have had lower correlations with emerging market returns than with those of other developed markets.

Emerging markets also have attractive attributes that could contribute to strong future growth:

  • Favorable demographics: The populations of nearly every developed country—with the significant exception of the U.S.—are expected to begin shrinking before mid-century. While some developing countries face similar futures, many have large, young populations that are increasingly moving to urban areas for employment opportunities.
  • Growing consumption: Emerging markets' economies historically have tended to focus on exports—producing goods to be shipped abroad to wealthier countries. Many economists predict a shift away from this model toward domestic consumption-led growth as incomes rise and populations migrate from poor rural areas into cities.
  • Relatively low debt levels: Emerging markets tend to have lower debt burdens than developed countries. Thanks to robust growth and spending restraint, many emerging market governments and corporations have healthy balance sheets. Citizens of emerging markets also tend to have high savings rates, which bodes well for future spending should savings rates eventually fall to levels closer to their developed market counterparts.
  • Room for productivity gains: Productivity in emerging markets has greatly lagged that of mature economies. Analysts predict that better infrastructure and technological advances in emerging markets could greatly boost productivity, a major factor in sustainable economic growth.

What are some of the risks of investing in emerging markets?

Emerging markets offer the potential for above-average investment returns. Of course, one of the basic tenets of investing is that higher returns entail higher risks. Among the risks that investors in emerging markets must consider are:

  • Currency risk: When investing in any international market, investors face the risk that exchange rates will move in an unfavorable direction. For instance, if the foreign currency in which an investment is denominated declines in value relative to the dollar, it could reduce gains or magnify losses for U.S. investors in dollar terms.
  • Inflation risk: A mix of strong economic growth and insufficient monetary restraint can result in high inflation, a problem that has periodically cropped up in emerging markets. Runaway inflation can devalue currencies, hurt corporate profit margins, and abruptly slow economic growth.
  • Institutional risk: The nascent capital markets in much of the emerging world lack the accounting standards and regulatory framework seen in more-advanced economies. As a result, investors may have limited protection from fraud or inadequate disclosure of material information.
  • Liquidity risk: Emerging markets typically have much lighter trading volumes and a smaller number of participants than developed markets, which creates the risk that investors wishing to sell will not be able to readily find a buyer for their shares at a desired price. Illiquid markets can result in wide price fluctuations in a short period of time.
  • Political risk: Investors in international markets face the risk that political changes could adversely affect investment returns. Many emerging markets have a history of government instability or have only recently opened their capital markets to foreign investment. Political uncertainty, geopolitical conflicts, or unexpected government actions could weigh on returns or, in a worst-case scenario, result in the inability to sell an investment.

Risks such as these, along with investor speculation, have led to historically higher volatility in emerging markets.

How can investors gain exposure to emerging markets?

Stocks of the largest companies domiciled in emerging markets may be available for purchase through a brokerage, either directly or via an American Depositary Receipt—a certificate issued by a U.S. bank that represents ownership of a specific number of shares of a foreign stock.

Investors may also opt for indirect exposure to emerging markets by buying shares of large-cap multinational companies that sell their products to the developing world's burgeoning middle classes. Investments in these firms are not a perfect substitute for direct investment in emerging markets, however, since revenue from emerging markets likely represents only a portion of total sales.

An emerging markets mutual fund provides a simple and cost-effective way to gain access to emerging markets. Such funds may buy stocks or bonds across the emerging market universe or focus on particular regions or industries. Investors should note that emerging markets funds, especially those with a narrow focus, tend to be riskier than more-diversified funds that are focused on stocks in developed countries. As a result, emerging markets funds should represent only a small portion of a long-term investor's well-diversified portfolio consisting of a mix of domestic and international stocks and bonds. A simple option for building such a portfolio is a professionally managed mutual fund that allocates its assets across a variety of securities and regions, including emerging markets.