Emerging markets have underperformed in recent years, but some analysts believe a resurgence is overdue. A report from RBC Capital Management notes some promising trends for these up-and-coming economies. China’s dominance of the segment has lessened, emerging-market currencies have shown strength and the U.S. trade war likely won’t involve some important emerging market economies—namely, India, Brazil and South Africa.
Does this mean it’s time to expand your portfolio beyond developed economies? Let’s discuss the pros and cons of investing in emerging markets, how much you should allocate to the segment and three ways to fulfill that allocation.
What Are Emerging Markets?
Emerging markets are economies in transition from developing to developed. They are economic adolescents: They show some characteristics of fully developed countries, but they remain less sophisticated than the U.S., U.K., Canada, Germany and others. Relative to developed nations, emerging economies demonstrate:
- Lower income levels and living standards
- Less advanced infrastructure and industrialization
- Greater political, judicial and regulatory instability
Investment research firm MSCI includes 24 countries in its emerging markets index. Six of the top emerging markets are China, India, Brazil, South Korea, Taiwan and Mexico, according to Nasdaq Contributor Prableen Bajpai.
Potential Advantages Of Investing In Emerging Markets
The advantages of investing in emerging markets include higher growth potential, diversification benefits and attractive valuations.
Higher Growth Potential
Emerging markets can grow quickly. You can see the growth potential informally by reviewing the history of iShares MSCI Emerging Markets ETF (EEM), which tracks the MSCI Emerging Markets index.
The ETF grew 338% from April 2003 to December 2007, which averages about 96% annually. In the past five years, the fund has appreciated 8.4% annually on average and is up 11.2% over the last 12 months.
To be clear, these growth periods have not been smooth and easy. The iShares ETF has demonstrated dips as extreme as its gains. Even so, the emerging markets fund outperformed the S&P 500 between early 2003 and 2010. Since then, the S&P 500 has pulled ahead.
Diversification Benefits
Diversification is a strategy for managing risk and volatility. By investing across sectors, company sizes, asset types and geographies, you incorporate varying behaviors into your portfolio.
Ideally, these varying behaviors have a mild offsetting effect when economic or financial market conditions change. Instead of watching all your positions lose value simultaneously, you might see some rise while others fall. The net effect is less extreme behavior for your portfolio as a whole.
Emerging markets contribute to this strategy. For example, Brazilian or Chinese equities may experience gains related to local conditions that wouldn’t benefit, say, Apple or Microsoft. Or, your domestic stocks may react more negatively to a U.S. economic recession than your emerging markets holdings.
Attractive Valuations
Emerging market stocks can be better values than domestic stocks. The P/E ratio of the iShares MSCI Emerging Markets ETF portfolio is 15.63. The fund’s P/B ratio is 1.97. Both metrics are modest relative to the S&P 500, which has a P/E of 28.39 and a P/B ratio of 4.87.
Potential Risks Of Investing In Emerging Markets
Emerging market stocks tend to be volatile, partly because they are subject to currency risk and political risk.
Volatility
With greater growth potential comes greater volatility. Emerging market stocks can fall as quickly as they can rise. For example, the iShares fund and the MSCI Emerging Markets Index lost half their value in the wake of the 2008 global financial crisis. They also dipped more than 35% between mid-2021 and late-2022.
Currency Risk
If the local currency loses value relative to the U.S. dollar, it can offset returns or magnify losses. Currency risk can worsen the normal volatility of emerging markets stocks. Purdue University’s Craig Brown notes that the current trade policy uncertainty will likely increase currency volatility globally.
Global U.S. companies like McDonald’s and Amazon also face currency risk. However, these companies generate a lot of revenue in the U.S., which limits the relative currency effects.
Political Risk
War, changing monetary policy and fluid regulations are political risk factors present in emerging market economies. These dynamics can destabilize the business environment, reduce earnings and shrink investment returns.
How Emerging Markets Fit Into A Diversified Portfolio
Emerging markets assets are too volatile to be core holdings, no matter how risk-tolerant you are. Their ideal role is a complementary one. Alongside more stable assets, emerging market securities can add upside and improve portfolio diversification.
How Much Of A Portfolio Should Be Emerging Markets
Many investors limit their emerging markets exposure to a single-digit allocation. Here are some allocation data points to consider:
- Investor and philanthropist David Swenson allocated 5% to emerging markets when managing the Yale University endowment fund.
- According to a 2021 Morgan Stanley analysis, global equity funds allocated between 6% and 8% to emerging markets.
- The MSCI ACWI Investable Market Index, covering about 99% of investable global equity, weights emerging markets at 9.1%.
The right allocation for your portfolio depends on your risk tolerance and investing timeline. You could start with a small allocation, say 2%, and then build your exposure as you get comfortable with these assets.
How To Decide If Emerging Markets Are Right For You
To decide if emerging market investing is right for you, consider two questions:
- Is your current portfolio working for you? If you are happy with your investment performance without emerging markets, then there may be no reason to change.
- Can you accept volatility for the diversification benefits? Focusing on the performance of your emerging markets securities in isolation may be stressful because they are so volatile. It helps to remember why you’re holding emerging markets: to enhance your portfolio diversification and upside potential.
Ways To Invest In Emerging Markets
There are three common ways to invest in emerging markets. The lowest-risk option is purchasing a global securities fund that includes emerging markets exposure. You can also pursue a more targeted emerging markets investment with a dedicated ETF. The riskiest approach is via American Depository Receipts (ADRs), which are stocks of foreign companies trading on U.S. exchanges.
1. Global Stock Or Bond Funds
Some global funds include emerging markets coverage alongside securities from developed countries. An example is Vanguard FTSE All-World ex-US ETF (VEU). The fund has more than 3,800 non-U.S. stocks from around the world. The emerging markets securities account for 26.4% of the portfolio.
2. Emerging Market Stock Or Bond Funds
You can alternatively invest in a dedicated emerging markets fund. iShares MSCI Emerging Markets ETF (EEM) holds more than 800 emerging markets stocks. Another option is Vanguard Emerging Markets Bond Fund Investor Shares (VEMBX), which holds primarily government bonds from Mexico, South Africa, Turkey, Brazil, Peru and others.
3. Emerging Market Stocks On U.S. Exchanges
If you prefer individual positions, you can seek out emerging market stocks trading on U.S. exchanges. Examples include chip foundry Taiwan Semiconductor (TSM), Chinese tech company Alibaba (BABA) and PDD Holdings (PDD), an ecommerce company that originated in China.
For more investing ideas, see best stocks to buy for 2025.
Bottom Line
Emerging market securities have risk, but they add a new layer of diversification and upside potential to your portfolio. If you decide to invest, move ahead with a small allocation to funds or individual stocks, and build your exposure over time.
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