Over the past year, emerging markets have generated exceptional media buzz. The story line goes something like this: After the Great Recession of 2007-2008, developed countries (the United States, Canada, Western Europe, Japan, Australia and New Zealand) are limping forward with stubbornly high unemployment and sluggish economies. To make decent profits, investors need to look abroad and invest in the booming economies of emerging-markets countries.
These stories raise several questions, which I'll try to answer:
Which countries are they talking about?
A cursory Google search leads to the conclusion that emerging markets is a loosely defined term. The general concept is that an emerging-market country is in transition from a closed, often centrally planned, economy to an open-market economy with transparent and efficient capital markets, an established exchange-rate system and clear accountabilities. So, the term emerging markets is a big tent whose occupants depend on whom you consult.
Probably the best known list of emerging-market countries is that of the MSCI Emerging Markets Index. This index consists of stocks of 21 countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The FTSE Group has a similar index, but it excludes Korea and adds Pakistan and the United Arab Emirates. Elsewhere, the Dow Jones Emerging Markets Total Stock Market Index is a much bigger tent and includes stocks of 40 emerging-market countries.
What is the risk-reward trade-off compared to developed markets?
While views differ on which countries have emerging-market economies, the key take-away is that any country making an emerging-markets list is undergoing a transition toward a more open economy. Invariably, there will be bumps along this road, which could negatively impact investor returns. For example, a country could suddenly devalue its currency, as Mexico did in 1993, instantly reducing the value of Mexican stocks in terms of Canadian dollars.
Fortunately, emerging-markets economies tend to be fast growing and compensate investors with higher rewards for taking on such risks. In general, returns have far outpaced developed global markets over the past 10 years, and future growth prospects seem bright.
I think it makes sense to hold a portion of one's equity portfolio in emerging markets, given the potential for above-average profits and the benefits of greater diversification by country, by industry and by individual stocks.
How can the average Canadian invest in emerging markets?
For a host of reasons, trading directly on emerging-market stock exchanges is not a route I would recommend. There may be a lack of reliable company information in a language you understand, and the accounting and disclosure rules are materially different from here at home.
Fortunately, there are other choices for Canadian investors who are seeking emerging-markets exposure, some of which are purer plays than others.
Your choices will depend, in part, on whether you prefer to invest directly in the stocks, or hold them indirectly through mutual funds or exchange-traded funds. For fund investors, other considerations include deciding between actively managed and index-style approaches, the latter providing low-fee alternatives.
The different types of investments are: