We explain everything you need to know about emerging markets, including what they are, why they are worth considering and how to invest.
What is an emerging market?
‘Emerging markets’ is a term that is widely-used but loosely-defined. Emerging markets are economies that show some of the traits of developed economies but aren’t quite at the same level yet.
There are three categories of economies: developed or advanced, emerging and frontier. An emerging market economy is considered to be progressing towards becoming advanced, with regulatory bodies, a market exchange, and some liquidity in its debt and equity markets. However, it doesn’t have the same level of regulation, oversight or market efficiency that an advanced market has. This means they are defined as emerging markets not only by the way the economy is performing but how it is being reformed and developed. An emerging market grows faster than an advanced one, but an advanced market delivers steadier, more reliable growth over sustained periods of time.
A frontier market is the stage before emerging and is used to classify smaller developing countries that have yet to be recognised as having an emerging economy. These tend to be the poorest countries that are either not experiencing rapid growth or attempting to open up the economy.
What are the characteristics of emerging markets?
In a nutshell, the defining characteristic of an emerging market from an investor’s point of view is that they offer faster growth than advanced markets, but they also carry more risk and tend to be more volatile. Below is a list of some typical characteristics:
- They are going through a period of industrialisation and experiencing above-average economic growth
- But with below-average per capita income (relative to advanced economies)
- They have fast-growing populations and an emerging middle-class
- Their currency tends to be exposed to more volatile swings with currencies of advanced economies, particularly the US dollar
- But they are often trying to reform their exchange rate mechanisms to increase the stability of their currencies to discourage citizens from sending their money overseas and encourage investment from abroad
- They also tend to be vulnerable to swings in commodity prices like oil or agricultural goods
- They have implemented plans to reform the economy, usually toward an open market one that engages more with the rest of the world
- They are attempting to introduce greater accountability and transparency into the economy and financial system to build confidence among foreign investors
What countries are the largest emerging markets?
Global organisations such as the International Monetary Fund (IMF) and the World Bank – as well as the numerous index providers that track emerging markets – follow different definitions and classifications. This means there is some disagreement over the status of some countries, but there are some countries that all agree are emerging markets.
A good starting point would be the E7, otherwise known as the Emerging 7, which was a term coined by economists at PricewaterhouseCoopers in 2006. This groups together the seven largest emerging markets in the world, which are outlined below and ordered by size. The top four are also referred to as BRIC countries. The E7 have been at the forefront of global growth in recent decades. The E7 was about half the size of the G7 in 1995, according to PwC, but roughly matched the group in size by 2015. Estimates suggest that the E7 could be twice as large as the G7 by 2040.
(Source: IMF, 2019 forecasts)
The theory is that growth in emerging markets outpaces that of advanced ones to eventually close the economic gap between the two in terms of GDP and income per capita. PwC forecasts the E7 will experience annual average growth of around 3.5% between 2016 and 2050, well ahead of the G7’s forecasted growth of 1.6%.
The MSCI Emerging Market Index
The Morgan Stanley Capital International Emerging Market Index is one of the most widely-cited indices when discussing emerging markets. Having started in 1988 with just 10 countries, the index has grown to include over 25 countries today. Below is an image outlining how the index classifies developed, emerging, frontier and other countries as of June 2019:
|Developed Markets||Emerging Markets||Frontier Markets||Standalone*|
|Hong Kong||Hungary||Lithuania||Trinidad & Tobago|
(Source: MSCI EM Index. * Standalone countries are measured using same criteria but only included in standalone indices. **West African Economic & Monetary Union includes Benin, Burkina Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal and Togo.)
How to invest in emerging markets
For investors, the purpose of emerging markets is to gain exposure to greater risk for greater reward. We have established that emerging markets will grow faster than advanced economies but that this growth will be more volatile and vulnerable. Compared to advanced economies, emerging markets are more likely to start pedalling backwards and could see the reintroduction of political or economic uncertainty.
Take Greece as an example. The country was one of the original countries to form part of the MSCI Emerging Market Index in 1988 but was then removed in 2001 when its debt crisis started to unravel. Greece was reclassified as an emerging market by the index in 2013, demonstrating how the classification of countries can change.
Directly investing in emerging market stocks
Investors have a number of ways to gain exposure to emerging markets. They can directly invest in companies listed on stock exchanges based in emerging markets, like India’s NSE or BSE. However, investors have to spend a lot of time researching the country and stocks to ensure they fully understand what they are doing.
They could also look to invest in UK-listed stocks that operate in emerging markets, like Infrastructure India, which is based in the Isle of Man, listed in the UK and solely invests in Indian infrastructure projects, mostly in energy and transport. This way, investors get the best of both worlds: exposure to emerging markets but through a company that meets the high reporting and transparency standards as a UK-listed business. Or alternatively, they could invest in companies that are based in emerging markets but listed in the UK.
Emerging market ETFs: broad exposure
Emerging market ETFs are the easiest and simplest way to gain exposure, and investors can save time as they don’t have to do as much research about individual stocks or countries. There a number of broad emerging market ETFs that track the performance of stocks from numerous countries. However, also look at the weightings of these broad ETFs because they can often be weighted in favour of one particular nation, usually China because of its dominance. For example, China accounts for 33% of the weighting of the MSCI Emerging Market Index, which is more than double the exposure it has to any other country.
The Vanguard Emerging Markets Government Bond ETF seeks to track the return of the MSCI Emerging Markets Index (with net dividends reinvested) in Australian dollars. Like the MSCI, China accounts for 32% of the weight. The top company holdings include Alibaba Group, Taiwan Semiconductor Manufacturing, Samsung and Tencent Holdings. There is also the iShares Core MSCI Emerging Markets IMI UCITS ETF to consider.
The Schwab Emerging Markets Equity ETF aims to track the performance of the FTSE Emerging Index. It again has large exposure to China but has greater exposure to countries like Taiwan and India compared to those tracking the MSCI index.
The Aberdeen Emerging Markets Equity Income Fund is another one to consider. It does not track another index but simply tries to deliver both short and long-term appreciation. It is most exposed to China, but this is less than 20% so below that of other ETFs.
Emerging market ETFs: country specific
We can see that broad emerging market ETFs tend to favour countries like China. This could be a problem as the ETF’s performance is highly reliant on one country. This is not ideal for investors that either want to spread the risk more or want to gain more exposure to a particular country. Instead, these investors should consider country-specific ETFs to get the exposure they want.
For example, iShares have ETFs covering individual countries – including China and India. You could build your own specific portfolio by investing in multiple specific-country ETFs, or use them to compliment one with broader coverage.
Emerging market ETFs: sector specific
If investors want to get even more specific exposure then consider ETFs that focus on a particular sector. For example, the iShares Emerging Market Infrastructure UCITS ETF tracks the performance of the top 30 listed entities involved in infrastructure projects, while the EMQQ Emerging Markets Internet & Ecommerce UCITS ETF tracks the performance of firms that operate things like search engines, social media platforms and digital payments. This allows you to not only tap into emerging markets but the fastest growing segments of those markets.
Emerging market ETFs: minimum volatility
We have established that emerging markets offer greater reward in return for greater risk, but there are ways to reduce the volatility. There a number of ‘minimum volatility’ ETFs that track more stable companies in emerging markets, which tend to prove more resilient than other ETFs.
The iShares MSCI Emerging Market Minimum Volatility UCITS ETF ‘seeks to minimise the market’s peaks and valleys’ that emerging markets offer. It includes ‘selected companies from emerging markets countries that, in the aggregate, have lower volatility characteristics relative to the broader emerging equity markets.’ These include stocks involved in more stable sectors like telecoms and finance. The MSCI Emerging Markets Index fell 14.6% in 2018 whereas the iShares’ minimum volatility ETF lost only 6.3%, demonstrating how much more resilient these types of ETFs are – but remember this means it could report lower gains when times are good.
There is also the Lyxor FTSE USA Minimum Variance UCITS ETF, which aims to track the performance of the FTSE Emerging Minimum Variance Net Tax Index that comprises of large and midcap companies in emerging markets with ‘reduced risk’ by ‘selecting stocks with low correlation with one another.’
How to trade emerging markets
Most emerging markets are heavily influenced by developments in advanced economies. For example, any drastic movements in the US dollar usually has a large impact on the currencies of emerging markets. With this in mind, there is an opportunity for traders to gain broad exposure to emerging markets to trade around major occasions, like Federal Reserve meetings or geopolitical events.
For example, the ever-changing nature of the US-China trade war, the Fed’s interest rate decisions or any events that change the value of the dollar can be great times to trade emerging markets.
How to invest in emerging market debt
The last area to take note of is emerging market debt, which again can be attained by gaining exposure through ETFs. Investing in emerging market debt can compliment any investments made in equities because bonds generally present less short-term risk and volatility than stocks – although they are subject to additional risks such as movements in interest rates or inflation.
The Vanguard Emerging Markets Government Bond ETF allows you to gain exposure to US dollar-denominated government bonds in emerging economies. Over 60% of the portfolio is made up of emerging market debt, with Mexico, Indonesia and Saudi Arabia the three biggest components.
The iShares JP Morgan $ Emerging Markets Bond UCITS ETF also tracks US dollar-denominated debt in emerging markets, with investment grade and high-yield government and quasi-government bonds.
Lastly, there is the SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF. It is designed to provide a broad measure of the performance of liquid local currency emerging markets debt, and limits exposure to an individual country to 10%.