Promise And Promise Of Emerging Markets

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Includes: ADRE, DBEM, EDBI, EDC, EDZ, EEM, EEME, EET, EEV, EMCR, EMF, EMFT, EMLB, EMSA, EUM, EWEM, FEM, GEM, GMM, HEEM, IEMG, KEMP, KLEM, LLEM, MSF, SCHE, VWO, XSOE
by: Evans Osemwegie

Summary

Investing in the emerging markets can be more profitable on a risk/return basis.

Emerging markets offers good diversification opportunities to a standard portfolio.

Investing in emerging markets has to be done strategically as various trends may take years to develop.

As an investment advisor that migrated from an emerging market economy (Nigeria) to a highly developed market (UK) and now to an emerging economy (Latvia), I have a very unique understanding of how the emerging markets work.

I am frankly very surprised that it is not more widely discussed, as it does promise lots of opportunities and I am disappointed with the various emerging markets indexes. The only one I was remotely impressed with was the Vanguard FTSE Emerging Markets (NYSEARCA:VWO), which was by far the most diversified of most of the available emerging markets indexes.

Despite this, most of the indexes make the same mistakes with emerging markets, because their portfolios are full of BRICS nations, commodities, basic materials, consumption and financial services.

While these were good starts, they do not adequately capture the thesis of emerging markets investments, which can be categorized in three words: aspirational, development, and long term.

Aspirational - means that the populations of these nations want to prosper. They really believe it is their time to prosper and they take whatever is being done in the mature economies and transform it to great success in their local markets. A good example is mobile banking, which is linked to the explosion of technology start-ups we are seeing all over the emerging markets from Nairobi, Kenya to Tehran, Iran.

The internet has leveled the playing field around the world and with the growth of online education, young people in these nations have access to possibilities that were unthinkable even a decade ago. This causes me to scoff at economists who plot the growth of emerging markets based on the past performance.

This is incorrect and shares the same weakness of technical analysis, which tries to predict the future by looking at the past, when, instead one has to look at the conditions, as this is what drives the markets, not past prices, which is merely an effect, not a cause.

Development - this thesis can be a problem with international investors who are always seeking short-term returns. Development is adding value to the local community where you are investing rather than simply extracting.

An example of this is working with the government to improve the road while you finance an investment in a shopping mall or you invest in a local school while you are also investing in a factory. These goes hand in hand, they are not divorced from one another.

Long term - is speaking about the need for patience, so we can allow our emerging markets investments to blossom over the long term.

Benefits

In times of benefits, dollar adjusted returns are generally up to 10% on average, sometimes even more, but it can fall if the currency falls against the US dollar due to currency fluctuations.

It also offers an excellent diversification tool, as it is inversely correlated to the US dollar and other low-yielding currencies, like the euro and the yen, due to the carry trade.

A good risk management strategy is to factor in the risk of currency loss as part of your investment and hedge this risk by using out of the money option spreads.

Furthermore, emerging markets is a higher risk investment, so one must ensure that the higher risk/return is offset other lower risk/lower return assets in one's portfolio.

Pitfalls

Investments in emerging markets can be a challenging one for investors of all levels of experience, firstly because of development challenges. An example of this can be that the rise of consumer spending and retail may be on the rise, but without corresponding growth in infrastructure, environmental awareness, education and social policy, it is unlikely that the consumer spending will be sustainable in the medium to long term.

Having said that, investment in development can be seen as an indicator of attractive investment opportunities and investors should not waste the opportunity to piggyback on the development efforts of government and other international organizations.

Another pitfall is lack of market access, as from the outside, it may be difficult to understand how to enter and take advantage of investment opportunities. In many cases, one will be better served going with a more experienced partner or a local partner.

Another concept to be aware of is different cultural understanding. One cannot invest from a mature economy mind-set, but one must research the people and the culture first, to understand what type of investments will be attractive.

An example is the banking industry, everyone agrees, that banking could be a great investment when we look at the potential market size, but it is important to remember that in a mature economy, banking is as much a utility as it is a cultural phenomenon. This is because we are socialized into using banks, to store our money, and of course, the system allows for cashless transactions, but in those places where cash dominates (unless there are other benefits like microfinancing), it can be difficult to sustain a banking structure, even in the cities.

Another example within financial services will be insurance. The needs in emerging market for insurance is as much for protection as it is for aspiration. People also want to save money for their children's education, buy a house and so on, and insurance needs to help them to do this better, in addition to protection.

Finally, religious turmoil is a risk that cannot be ignored as it is reshaping our world in such a fundamental way.

Process

Now, we will begin to look at the process of investing in emerging markets.

The first advice is to start with a country you know well, and have either been or will be willing to go to a number of times, to get a feel for the region and the people.

This will also give you an opportunity to do the next part of the process, which is to select a group of advisers that can help to guide you through the process of investing in these markets.

It is also important, as I mentioned above, to piggyback on sectors in which the governments are already making investments in order to reduce risks and increase returns.

Finally, remember the commodities markets, as in the short term, it affects different emerging markets differently.

In summary, the emerging markets are significantly underpriced as investors have made some erroneous assumptions such as concluding that a downturn in China means extended low commodities prices and further that this means a downturn in emerging markets securities.

However, this is not the case because there is a substantial amount of internal demand for global commodities that is beginning to come from various emerging markets like Sub-Saharan Africa, so while the world is looking at China's demand normalizing, they are missing an even bigger and more sustained commodities demand from markets like the Middle East and Africa with their young populations.

In terms of how one ought to invest; within the stock markets, the companies who do well are the market leaders in sectors like construction, infrastructure, transportation, financial services, electricity providers and consumer companies, particularly food.

These opportunities persist in every emerging market, other developing sectors include technology, healthcare and entertainment but at the moment, these still exist mainly at the venture capital stage but the potential is incredible.

To really capture very high returns in emerging markets, one needs to work with the early stage investors, and a good place to start is with banks like Standard Chartered who can advise serious investors of the best funds in these regions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.