Emerging markets have characteristics that are attractive to individual investors but also make them difficult to access. The market capitalization of emerging market countries is $9.9 trillion, which is approximately 20% of the world capitalization, making them an important part of the global economy. These markets are in countries that generally are experiencing rapid economic growth, are opening up their markets to foreign investment and are in the process of liberalizing both their governments and their economies. Unlike developed country markets, emerging country markets are still shaping and developing their securities market infrastructures. Emerging market stocks provide significant opportunities for increased returns but also heightened risks.
Reasons to Invest
There are a number of compelling reasons to invest in emerging markets. Emerging market countries are undergoing a liberalization of their financial systems and allowing access to new trading opportunities. Many of these markets have been closed off or have restricted trading to only domestic investors. As these markets open their exchanges for physical trading and, in some cases, also for derivative trading, they offer foreign investors new opportunities for diversification and higher returns.
As demonstrated by Table 1, the returns of the iShares MSCI Emerging Markets Indx (NYSEARCA:EEM) and the SPDR S&P 500 (NYSEARCA:SPY), are not highly correlated with one another, particularly over the more recent periods after the returns experienced during the financial crisis drop off. In addition to lower correlations, as seen in Table 2, these markets offer higher returns due to their rapid growth stage economies.
Correlation EEM/SPY Monthly
Sources: FacSet, IndexIQ research
*Dated through 7/29/2011
Emerging Market equities and in particular Emerging Market Mid-Cap Stocks have provided attractive performance.
Past performance is not a guarantee of future results. Data for the 10-year period ending 1/31/12. Sources : FactSet Morningstar and IndexIQ
Emerging Market Risks
Because there is no free lunch and almost no existing opportunities for free arbitrage, emerging markets, despite their potential for the higher returns, do come with a number of increased risks that investors have exposure to when they invest in these markets.
Emerging Markets do have different and more risky characteristics than developed markets which generally have enabling political systems, peaceful transitions of power by which all agree upon a process where power can be transferred from one regime to another, and an ideal bureaucracy that tends to operate as a meritocracy. Effective financial systems have the ability to channel funds and provide liquidity and leverage. Although many emerging markets currently lack the solid foundation necessary to maintain stable economies and markets, they are in the process of instituting significant reforms to improve their economic and securities infrastructures.
While developed markets were and are currently going through both a sovereign debt crisis in Europe and the debt ceiling debacle in the US, certain emerging market countries have taken steps to improve their local infrastructure. "Policy makers have already taken steps to slow credit growth. Brazil raised reserve and capital requirements on some loans in December, doubled to 3 percent tax on consumer credit in April and required banks to hold more capital against certain credit-card loans last month. The Reserve Bank of India has asked lenders to set aside more cash for bad loans … China raised banks' reserve requirements 12 times since the beginning of 2010."
Although many emerging market countries have allowed foreigners to invest in their securities markets, foreign investors tend to receive different treatment. Differences include lower dividend payments, different classes of stock and various tax issues including withholding tax.
Unlike the U.S. where the securities laws are quite mature and very stringent, emerging markets have much looser regulatory standards. Issues with honesty and fair dealing, such as front running can be still quite prevalent.
Emerging market securities can be highly illiquid. The liquidity characteristics can be low trading volumes, high bid-ask spreads and limited trading times. In many Asian countries, for example, closely held issuers reduce the available float while restrictions on foreign ownership can reduce liquidity further.
One of the significant risks in investing in emerging markets is currency risk, primarily due to unstable monetary and fiscal policy within these economies.
"The Asian crisis first emerged in Thailand in 1997 as the baht came under a series of increasingly serious speculative attacks and markets lost confidence in the economy. On August 20, 1997, the IMF's Executive Board approved financial support for Thailand of up to SDR 2.9 billion, or about US$4 billion, over a 34-month period. The total package of bilateral and multilateral assistance to Thailand came to US$17.2 billion. Thailand drew US$14.1 billion of that amount before announcing in September 1999 that it did not plan to draw on the remaining balances, in light of the improved economic situation."
Emerging market ETFs cover the range of the market capitalization spectrum from large to mid to small covering the top 70%, 15% and bottom 15%, respectively.
IndexIQ is one of the few fund families that offers an emerging markets mid cap product that trades under the ticker EMER.
This exchange-traded fund (EMER) offers unique diversification benefits not only through market cap, but also across countries and sectors and can be a complement to large and small cap emerging markets exposure.
However, managing a mid cap emerging markets ETF does not come without its own unique challenges. The most important step in gaining access is launching and running the emerging markets ETF. Most of the launch requirements are similar to other types of ETFs but there are a few unique challenges with EMER. The usual steps of listing on an exchange, securing a lead market maker and obtaining seed capital for at least the first 100,000 shares are standard practice for a US listed ETF. The biggest challenge is that not all emerging markets allow the typical ETF creation/redemption in-kind transaction (Authorized Participant to ETF custodian) and, instead, require trading and converting US dollars to each of the local market currencies that would only allow cash in lieu transactions. For example, South Korea and Taiwan both require some type of pre-funding prior to trading the currencies in order to get an execution with the same trade date as the equities. Since currency risk can be significant, executing the equities and currencies on the same day is crucial. Other countries like Brazil which until just recently had a currency tax of 2% for all Brazilian real (BRL) buys. India requires that foreign investors pay economically prohibitive high taxes and therefore are usually traded on swap. Although there are many challenges in trading and managing an emerging market ETF, these markets offer many opportunities for diversification and higher returns.
Source: FactSet as of 1/26/2012
The chart above illustrates that not only can you gain significant diversification benefits by investing in an emerging markets ETF but you can maximize that benefit by combining your exposure to an emerging markets large cap fund with an allocation to EMER (Mid cap emerging markets). By allocating to both within your total emerging market exposure, an investor can get a much better cross section of industry exposures in those regions.
Complete Market Capitalization
Source: FactSet as of 1/26/2012
The same diversification benefits hold for allocation to both the large cap emerging market product and EMER when you breakdown the market capitalization exposure you achieve from a combined exposure. If you only select the large cap emerging market product, you hold the largest companies that can be more correlated with the developed markets but by adding EMER you can see that you cover the entire market capitalization spectrum and eliminate size bias.
Sources: FactSet, IndexIQ Research as of 1/26/2012
Source: FactSet, IndexIQ Research as of 1/26/2012
The same diversification benefits hold for allocation to both large cap emerging market product and EMER when you breakdown the country exposure you achieve from a combined exposure. If you only select the large cap emerging market product, you hold a significant percentage in BRIC nations that can be more correlated with the developed markets but by adding EMER you can see that you cover a broader spectrum of EM nations.
EMER is also very highly correlated to the MSCI Emerging Markets Mid Cap Index and also has a very low correlation to the large cap emerging market product. Both of these characteristics make a great case for a combined investment in the large cap emerging market product and EMER.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I manage Funds that hold positions in EEM and SPY and manage the EMER ETF.