Emerging markets continue to attract the attention of investors the world over. Economic reforms, the expansion of the European Union, and changing political climates worldwide may create more investment opportunities as well as pose additional challenges and uncertainty in the years to come. If you are a long-term investor with a high tolerance for risk and the need for added diversification, you may want to explore the potential benefits of making emerging markets a part of your portfolio.
Emerging markets defined
Emerging markets are those of lesser-developed countries, which are beginning to experience rapid economic growth and liberalization. Examples of emerging market countries include China, India, and Mexico. Generally, these countries are described by a growing population experiencing a substantial increase in living standards and income, rapid economic growth, and a relatively stable currency.
Often, emerging market countries impose strict limits on foreign investment in an attempt to limit foreign ownership of domestic companies. Investors may be prohibited from owning more than a fraction of any one company, and they may also be restricted from repatriating profits from investing activities.
Investors in international securities can be subject to somewhat higher taxation and higher currency risk, as well as less liquidity and risks of social and political changes, compared with investors in domestic securities. There may be also differing accounting standards and different regulation of securities markets. Past performance does not guarantee future results.
Asia: Potential rewards and liabilities of emerging markets
The potential rewards -- and risks -- of emerging market investing can be readily seen from the experiences of investors in Asia from late 1997 to 1999. A major collapse in emerging markets began with Asia in July 1997, when the Thai government was forced to dramatically devalue its currency, the baht, after failing to defend it in the face of a very large currency-account deficit, foreign debt, and a government budget shortfall. The result ricocheted throughout Asia as currencies in the Philippines, Malaysia, and Indonesia came under attack from speculators. Meanwhile, financial panic seeped into emerging markets throughout the world, from Latin America to Russia, as financial difficulties surfaced in those nations as well.
Despite measures including a "rescue package" (eventually worth about $42 billion) directed at Thailand by the International Monetary Fund (IMF), and promises of dramatic economic reform from Indonesia's government, investor confidence failed to return to most emerging markets until 1999. That's when signs of economic recovery began to appear in some of the troubled emerging markets, while others were boosted by deals with the IMF to help improve financial and economic conditions.
Lessons from the Asian experience
After the Asia crisis, many investors now realize there's no "free lunch" on Wall Street -- the high return potential of emerging markets investing comes with high risk, and many factors can trigger trouble. For example, the Thai baht's collapse began with lack of regulation among Thailand's real estate companies, causing a host of financial problems for that nation's government. The banks of both South Korea and Indonesia had unsound lending practices. And, in Brazil, a growing federal budget triggered doubts by potential investors that the nation could ever repay its debts.
It is especially important to note that the fortunes of one nation can increasingly affect those of another, as trading ties become tighter between most nations. As one nation devalues its currency, others may be forced to do so in order to keep their exports competitive, as some nations did when Thailand devalued the baht. When Asia's troubled economies cut their oil purchases, energy-producing nations such as Russia and Ecuador also suffered from falling petroleum revenue.
Currency risk can present another risk factor for emerging market investors. As the currency exchange rate fluctuates, so does the value of your investment in U.S. dollar terms. Fortunately, many emerging countries have their local currencies pegged to the dollar, which can result in a relatively constant exchange rate, but they are still subject to volatility.
Emerging markets: An asset class for the long-term investor
Emerging markets can be volatile; they are considered appropriate only for suitable long-term investors with an investment time frame of 10 or more years. With such high risk potential, why invest in emerging markets at all?
To answer this question, you should first look at the economic fundamentals, which are the underlying support for any country's financial market. Many emerging markets have economic growth rates that greatly exceed those of developed countries.
Emerging markets also offer diversification benefits. Because these markets tend not to move in tandem with those of developed countries, they may be rising while other markets are falling. Hence, they can help reduce the overall risk of a portfolio.
Investing in emerging markets: Mutual funds offer an opportunity for an entry path
Be aware that emerging markets in general tend to be volatile, sometimes even when no serious problem presents itself in a specific market. Investors in emerging markets are therefore advised to potentially reduce risk through diversification among many different markets, and to maintain a long-term view.
A good way for an individual to efficiently invest in emerging markets is through a mutual fund. Emerging market funds concentrate on investments in these markets around the world or in a specific country or region. Some global and international funds may also hold a small percentage of their portfolio in emerging markets.
Also keep in mind that some funds that invest in stocks of emerging market companies may also invest in bonds issued in that country. In general, these funds may contain a greater mix of different types of securities than a domestic fund.
Mutual funds offer the advantage of diversification and professional management. Because emerging market investment management may require extensive, and expensive, on-site company research, annual fund management expenses associated with these investments may be higher than for other types of mutual funds.
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