Funds Investing in Emerging Markets

What Is an Emerging Market? 

An emerging market is the stock market of a developing country, a country
evolving from an agricultural or socialist economy to an industrial free market.
Emerging stock markets exist in about two dozen countries, although that
number changes frequently. Some countries leave the list of emerging markets
as their economies mature; others are added as they open stock markets and
begin developing capitalist systems. 

For example, in 1997 Portugal was dropped from an index that tracks the stock
prices of developing markets, whereas the Czech Republic, Hungary, and
Poland were added to the index. 

The primary investment appeal of emerging markets has been the high rate of
economic growth in some developing countries in recent years, combined, in
some cases, with stock valuations that appear reasonable in comparison with
more mature stock markets. Rapid economic growth has helped many local
companies to prosper, leading to rising stock prices. As Figure 1 shows, some
experts predict that over the next few years certain developing economies will
grow faster than some of the more mature economies. At times, price/earnings
ratios in emerging markets have been lower than those in some more established
stock markets. 

Why Invest in Emerging Markets? 

There are two main reasons to invest in the world's emerging markets. First is
the potential for higher returns by investing in faster-growing, higher-risk
markets. The second (and probably much more important) reason is broader
diversification. Each of these reasons deserves careful consideration by
prospective investors. 

Potentially Higher Returns

Over time, some emerging markets have provided higher investment returns
than the stock markets of developed nations, and many economists expect that
to continue. Those higher returns reflect the greater potential for economic
growth in developing countries, which should translate into higher personal
incomes and greater corporate profits. It is not unusual for a developing
economy to grow 6% to 7% in a year, far faster than the 2% to 3% that is
typical for a healthy, developed economy. Those higher growth rates are not
consistent for all emerging markets, however. In the mid-1990s, China enjoyed
growth rates exceeding 10% a year, while some Latin American economies,
such as Mexico's, shrank more than 6% in some years. 

Broader Portfolio Diversification

Developed economies in Europe, the Pacific, and North America accounted for
94% of the world's stock market capitalization at year-end 1997. Figure 2
shows the stock market capitalization of the total world market and of emerging
markets by geographical regions. 

Emerging market countries have widely varying economies, growth rates, and
stages of development. Thus, their markets' movements historically have had a
low correlation with market movements in developed economies, or even
among themselves. 

In other words, when one market is rising, there is a good chance that another is
falling. As a result, a small investment in emerging markets may offer investors
an opportunity for increased diversification that has, in the past, led to lower
overall portfolio volatility. 


What Are the Risks of Investing in Emerging Markets?

Emerging markets generally involve much higher risks than those associated with
developed stock markets. Investors preparing to commit capital to an emerging
market should be aware of at least four primary risks: volatility, currency,
illiquidity, and political risk. Some of these risks are common to all foreign
investments; others are unique to emerging markets or higher in emerging
markets. 

Volatility Risk

If history serves as a guide, stock prices are likely to move up and down
dramatically in emerging markets, especially in comparison with the stock
markets of developed nations. 

In addition, emerging markets are immature, sometimes vulnerable to scandal,
occasionally manipulated, and often lacking strong government supervision.
Accounting, disclosure, trading, and settlement practices may at times seem
overly complicated. Against this backdrop, many emerging markets have had to
cope with unprecedented inflows, and outflows, of capital in recent years.
The sudden movement of highly speculative, short-term capital has the
potential, as seen in Mexico a few years ago, of taking with it much of a
market's price support. Such sudden flights of capital, triggered by events in one
emerging market, can spread instantly to other nations. When stock prices
plummeted in Mexico and its currency collapsed in late 1994 and early 1995,
the pain quickly spread to other emerging markets in Latin America. 

Currency Risk

Movements in the world's currency markets can have a dramatic effect on
returns earned abroad. High returns from rising stock prices could be turned
into losses because of falling currencies, something that happened in Turkey in
1994. In that year, the Turkish stock market posted a strong one-year return of
31.5% as measured in Turkish lira, but a sharp decline in the value of the lira
created a 50.5% loss after converting the investment into U.S. dollars. 

Figure 3 provides other examples of the impact of currency changes. Note how
the 314.0% gain in Turkey in 1997 was reduced to only 118.1% after
accounting for currency loss. Similarly, Indonesia's small loss of 2.3% became a
35.2% loss after taking the currency loss into account. 

When a developing nation's currency is devalued and its stock market declines,
U.S. investors can also suffer exceptionally steep losses, as they did in
Southeast Asia during 1997. In late 1997, nearly every Asian stock market was
rocked by the actual and anticipated impacts of a currency crisis that first hit in
Southeast Asia and spread to South Korea. 

Most reported returns from foreign stock markets take into consideration the
effect of changes in currency rates, but it is rare for the currency changes to be
noted separately from the stock price changes, as we have done in Figure 3. 

One of the primary causes of currency risk in emerging markets has been
runaway inflation. Annual inflation rates of 1,000% or more are not without
precedent. While there have been some notable successes in controlling inflation
recently, for example, in Argentina and Chile—a potential resurgence of
inflation remains a threat to currency stability. 

Illiquidity Risk

Emerging markets are generally small, with fewer stocks listed and less trading
than is common in the stock markets of developed countries. A developing
country's entire market value, or capitalization, may be less than that of a single
large U.S. company, and many companies in some markets are closely held
family businesses. Shares of fewer than 200 companies trade in several markets
(such as Turkey and Argentina), and total daily trading volume may reach only a
few million shares. By comparison, more than 7,000 companies trade in the
U.S. markets, and aggregate daily trading volume averages more than 1.3 billion
shares.* The lower trading volume in emerging markets (their "illiquidity") means
that investors may not be able to buy or sell shares at a fair price whenever they
want to trade. In some cases, the financial markets have actually closed for
short periods, such as in India where the Bombay Stock Exchange closed for
three days in March 1995. 

Some countries also restrict foreign investments. In Taiwan, for example,
foreigners are permitted to own only a specified class of shares, which may be
available in limited quantities. In Chile, foreign investors must wait at least a year
to withdraw capital from the market. 

*Sources: Wilshire Associates, Nasdaq Stock Market. 

Political Risk

Many emerging markets are especially vulnerable to such political risks as coups,
assassinations, or paralyzing power struggles. Some are governed by dictatorships 
whose succession plans are shrouded in uncertainty. Governments moving
toward democracy may be grappling with long-standing political and social problems, 
and sudden retreats toward socialism could occur. Progress could also
be stalled by economic reversals that have often gripped emerging
economies. Equally important to consider is the risk of policy
changes that could be unfavorable to external investors. These changes could
include currency controls, taxation revisions, or, in a worst-case
scenario, expropriation of foreigners' assets. 

Managing the Risks of Emerging Markets Investing

Two effective strategies should be considered for reducing the high risks of
investing in emerging markets. Both involve diversification. First, the stock
markets of developing countries tend to act with a high degree of independence.
Thus, investing in a diversified portfolio of Southeast Asian, Latin American, and
smaller European markets reduces the risk relative to investing in any single
emerging market. 

Second, emerging markets are highly volatile, so they are not for investors with
a short-term outlook. More than a few speculators have been hurt by the
volatility of emerging markets in recent years. As those markets soared in the
early 1990s, speculators poured money into mutual funds that invest in
developing countries on the basis of their recent performance. Unfortunately,
many bought shares just as the emerging markets were peaking. When Mexico
and some other emerging markets crashed in 1994, those speculators pulled
out, having "bought high and sold low." 

The volatility that laid those speculators low, however, can work to the
advantage of the disciplined, long-term investor. One possible strategy is to
invest a fixed amount regularly over time (i.e., employ dollar-cost averaging)
rather than invest a single or an occasional lump sum. In simple terms, the
investor who buys shares at regular intervals, in consistent dollar amounts and
over a long period of time, pays a lower average price per share than the
average market price of the shares in question. This occurs because a constant
dollar investment automatically purchases more shares when prices are low and
fewer shares when prices are high. Of course, dollar-cost averaging does not
ensure a profit nor protect against a loss in declining markets. Because
dollar-cost averaging involves continually investing in securities regardless of
fluctuations in their prices, investors should consider their ability and willingness
to continue making those investments during market downturns. 

What Are the Costs of Investing in Emerging Markets?

In addition to higher risks, investors should be aware of the higher costs
of trading stocks in emerging markets. Brokerage commissions and custodial 
fees are substantially more expensive than they are in the developed markets 
of the United States and Europe. 

Several countries levy a tax based on a transaction's total value.
Quoted returns on emerging markets often do not include these
"real-world" costs, which are a significant drag on returns earned by
investors. Moreover, thin trading activity often leads to higher
"market impact" costs. Buyers of large blocks of shares, for instance, may have
to "pay up" to complete a transaction, and sellers may receive a "marked-down"
price. Overall transaction costs for buying a basket of emerging market stocks
can be as high as 2%. 

Source: Morgan Stanley Capital International.

