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What Are Emerging Markets?

August 23, 2022
6
min

Emerging markets represent important opportunities for investors, the main challenge for investors is to manage the degree of risk in seeking those higher returns.

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Financial markets in a country are considered fully developed when the economy becomes robust and industrial, political institutions and regulations are stable, and the rule of law is established. The leading industrial economies of post-World War II are considered developed markets, particularly the U.S., western Europe, Japan, Canada, Australia, and New Zealand. Other countries that aspire to developed-market status are referred to as emerging markets.

What is an emerging market?

Countries such as China, India, and Brazil are considered emerging markets because they are  making the transition from an economy dependent on agriculture and raw-material exports to one that is more integrated with industrialized nations. In other words, such a country is somewhere along the way to becoming a developed-market economy.

An emerging-market economy usually has these characteristics:

  • Gross domestic product (GDP) is growing faster than in the U.S. and other developed economies such as the Group of Seven countries, which includes the U.S., U.K., Canada, France, Germany, Japan and Italy.
  • Per-capita income is low, but growing, creating a potentially large middle class.
  • It has a financial system that is improving, with a single currency, a banking industry, and a centralized stock market.
  • Government promotes regulations and reforms that are meant to bring it in line with developed countries.
  • It offers higher potential returns for investors.

General descriptions aside, emerging-market countries don’t develop at the same pace, or in the same way. Some—such as China, India, and Brazil—are further along in modernizing and industrializing. Others like Indonesia and Nigeria have had uneven development, though their populations are much larger than all of the Group of Seven industrialized countries except the U.S.

Until the early 1980s, emerging markets were often referred to as Third World nations, a Cold War-era term that was seen as vague and potentially derogatory. About three-fourths of the world’s population lives in emerging markets, and these nations are forecast to account for 60% of the global GDP by 2030.

Classification of emerging markets

Economists and market professionals may classify emerging-market countries in various ways, using different mixes of economic and political criteria. Creators of benchmark indexes for emerging-market stocks also vary somewhat in which countries they include—their decision is often partly based on macroeconomic data analysis, and partly a judgment call. But in general, about 20 to 24 countries around the world qualify at any given time for emerging-market status.

The best-known classification is a group of the biggest emerging markets known by the acronyms BRIC and BRICS—shorthand for Brazil, Russia, India, and China (and sometimes South Africa).

Second-tier emerging markets number about a dozen and include South Korea, Mexico, Taiwan, and Turkey. Some economists have even separated a few of these countries—Mexico, Indonesia, Nigeria and Turkey (known as the MINT class)—for their stronger economic growth rates and investment opportunities.

As a country’s circumstances change—for better or worse—economists may decide to raise or lower a country’s classification. For example, Russia in 1997 was added to the Group of Seven, renamed the Group of Eight, only to be dropped in 2014 after it invaded parts of neighboring Ukraine.

Risks of emerging markets

Emerging markets, particularly the biggest BRIC and second-tier countries, continue their industrialization and development of sophisticated financial markets. Nevertheless, they pose a variety of risks to foreign investors, including:

  • Currency. Fluctuations in the value of emerging-market currencies affect the total returns from foreign investments. Stocks and bonds typically are purchased and sold in the local currency and must be converted to the investor’s home currency. If the local currency weakens against the investor’s currency, that erodes the total return. 
  • Economic. An emerging market may experience high inflation, often stemming from government spending and heavy taxation. Some emerging countries fail to follow a free-market form of economy, intervening to save or subsidize favored industries, or expropriating industries such as oil and gas production and mining. As a result, U.S. and European investors can lose their holdings. Additionally, labor unrest in emerging markets can cause shutdowns or work stoppages.
  • Political. Corruption, unstable government, or inconsistent government actions can jeopardize an emerging-market investment. Political instability also can lead to civil war, or conflict with other countries, which can disrupt the country’s economy.
  • Markets. Financial markets often aren’t as liquid as in industrialized nations, with higher fees for brokerage services. Foreign investors in emerging-market stocks face a greater risk that their buy and sell orders may get executed at substantially different prices than what they expected. Another risk is insider trading. As a result, stock prices can be skewed and leave foreign investors at a disadvantage.
  • Volatility. Historical data for returns often are not deep and robust, compared with U.S. and Group of Seven markets. In addition, emerging markets are still evolving. This makes statistical analysis of returns for forecasting  difficult and unreliable.
  • Corporate. Financial reporting and disclosure by emerging-market companies may be weaker than in developed markets. Corporate governance also may be weaker, meaning the company’s management (or the government) may have a bigger say than the shareholders, who have fewer rights and fewer ways to seek remedies through lawsuits or regulatory actions. Companies in some countries may engage more freely in manipulation of financial statements to look profitable. This increases the risk of their stock prices collapsing if a fraud is eventually exposed.

How to invest in emerging markets

Trying to pick winners among stocks in developed markets is a daunting task, and is even more so in emerging markets. One way for small investors to enter emerging markets is through funds, particularly index funds, which are already diversified across emerging-market countries and industries.

Many emerging-market index funds and exchange traded funds (ETFs) track one of several indexes that serve as benchmarks. Among them are the MSCI Emerging Markets Index, S&P Global’s Dow Jones Emerging Markets Index, and the FTSE Russell Emerging Index.

The MSCI, started in 1988, is the biggest such index. It includes more than 1,400 large-cap and mid-cap companies in 24 emerging markets. It is weighted by market cap, meaning the biggest companies by market value have greater representation.

Chinese companies now account for about 40% of the MSCI index’s weighting because of  the rapid growth of China’s economy and its stock market. Taiwan and South Korea account for about 12% each in the index, followed by India at 8%, and Brazil at about 5%.

The bottom line

Emerging markets represent important opportunities as well as trade-offs for investors: potentially higher returns than in developed markets, accompanied by greater risk of loss stemming from a variety of factors, from economic and political instability to currency volatility. 

The main challenge for investors is to manage the degree of risk in seeking those higher returns. Funds that invest in an array of emerging markets and assets (for instance, stocks and bonds), or that track a benchmark emerging-markets index, try to mitigate some of the downsides of investing in these markets.

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