Investing in emerging markets

Last week this column dealt with the topic of global investing. This week’s article will tackle a portion of that global portfolio – emerging markets (EM). According to World Bank figures as at end 2009, two of the top 10 nations ranked by GDP are now occupied by developing countries; this figure rises to eight if one had to consider the top 20 nations. China ranked third in this list, up from sixth in 2000.

In 2010 China surpassed Japan as the second largest economy in the world, second only to the United States, and according to a number of sources, it is forecast to surpass the US in the next 15-25 years. Economic figures and growth rates in emerging markets highlight the importance of considering emerging countries for the global investor.

Developing countries generally operate at productivity levels below those of more developed countries and hence should be in a position to close this gap at a faster pace.

The same principle applies to technological progress – the wider the “developing vs developed” income gap, the greater the potential for technological progress.

And, while the developing world’s population is shrinking, that of emerging countries is growing. These factors - especially when coupled with an increase in the rate of labour force participation – generally lead to higher economic growth.

The emerging economies more likely to excel are likely to be those with democratic political systems, efficient financial regulation, promotion of free enterprise and effective legal systems.

Emerging equity markets largely outperformed global equity market returns when taking both five and 10 year periods, and to a lesser extent, over the last one and three year periods.

The chart above compares percentage returns since April 2001 for MSCI World (bold function) and MSCI EM (dotted) indices. Over the 10-year period, EM returned 302 per cent versus 30 per cent for the World Index; returns over five, three and one year periods were 47.6 per cent vs 0.4 per cent, 2.8 per cent vs -10.2 per cent and 15.1 per cent vs 10.5 per cent respectively.

Foreign investors need to be careful when investing in emerging markets however, as these are sometimes illiquid and can be very volatile as seen in the chart above.

Furthermore, some developing countries control the amount of shares foreigners can hold in their companies, while they sometimes levy discriminatory taxes.

Other EM states impose restrictions on the repatriation of invested funds or restrict conversions from the local currency back into the foreign currency, especially during periods of crisis.

The solution we often use is through the selection of appropriate emerging market funds or ETFs.

In times of crises the return correlations among emerging markets tend to be higher, and the crisis in itself typically more prolonged.

When the crisis is due to factors outside the EM country, it may create contagion with other EM countries. Furthermore, high dependence on developed countries means recessions in the latter can also cause a crisis in the EM economies.

Investors should be cautious when investing in emerging markets. Higher returns generally come at the expense of higher risk.

However, although the standalone risk of emerging markets could be high, the incremental risk from adding a moderate amount of EM investments to a “global” portfolio could be more than offset by its rewards given the relatively low correlation of returns between developed and developing markets.

The shift in economic power is taking place and as developing economies become more important on the world economic stage, so global portfolios should increase their exposures to such markets.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business. Should one wish to discuss this article in further detail, he or she may contact the author on 2342 6116.

www.curmiandpartners.com

Mr Micallef is an investment executive at Curmi and Partners Ltd.