Tuesday, 23 August 2016

What is an emerging market?

There is some dispute among financial institutions about what exactly constitutes an emerging market, but what most of them seem to agree on is that the sector is likely to deliver the highest growth rates over the long-term. There is no hard and fast definition of an emerging market, but they are understood to include countries that have yet to achieve the standard of living and GDP per capita of the developed world – principally western Europe, North America and Australasia. 

The poorest countries in the world are not necessarily considered emerging markets: frontier markets are at a lower level of economic and political development. In theory, countries should be expected to move up the categories as they grow richer. Which category a country falls into is in the eye of the beholder: different institutions have different definitions. By and large they agree, but this is not always the case.

South Korea is an example of a country that sits on the border between two categories. FTSE considers it to have gained developed world status, while MSCI considers it to be an emerging market. Countries can even be demoted, with Greece seeing its status cut as a developed market by Russell last year, and MSCI and FTSE both considering doing the same.

All the risks associated with emerging markets are magnified in frontier markets, and recent history suggests it is much harder to make money in such funds. The MSCI Frontier Markets index was launched in February 2008 and data shows it has struggled since then compared with the emerging markets index. Many analysts suggest that frontier markets are too specialist for the majority of investors, and are more appropriate for investors with large portfolios who can better absorb losses and who want to diversify their riskier holdings.

Why invest in emerging markets? Emerging markets generally see higher economic growth than the developed world. Most commentators expect this to continue for many years to come. For those who invest in funds, there may be an additional benefit, in that emerging markets are less well-researched than their developed counterparts. There are fewer analysts working on the companies and fewer funds with local knowledge, meaning that it is generally accepted that managers are more likely to outperform the wider market. This means that the best funds in the sector have managed to beat their peers by a large amount.

What are the risks? Along with the higher growth potential associated with emerging markets comes higher risk. Data shows that the volatility of the MSCI Emerging Market index tends to be significantly higher than that of the FTSE All Share. There are a number of reasons for this on a company and fund level. Some funds have a better track record of managing those risks, and it is noticeable that those that sit at the top of the performance tables are run by fund houses known for taking a more cautious approach.

How can you invest in emerging markets?  Emerging markets are now a mainstream asset class, and it is rare to find an investor without an emerging markets fund in their portfolio. There is a large amount of choice: investors can buy a fund that specialises in emerging Asia, China, Latin America, south-east Asia, or even emerging European countries such as Russia and the old Warsaw Pact nations.

For most investors, a general emerging markets fund is likely to be more appropriate, advisers say, as the diversification they supply lessens the currency and political risks that are taken on with emerging markets funds. As always seek professional advice where appropriate.

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