Emerging markets offer risks and rewards
Investing in emerging markets offers substantial potential rewards over the longer term--and big short-term risks
The gains of these offerings were due in part to investors rediscovering their appetites for risk, and in part to these strategies' sharp falls in the late 2007 to early 2009 global meltdown, which gave them plenty of room to bounce back. Outperformance in 2009 was also due to investor excitement about improving macroeconomic conditions in the developing world. And most of the developing world's economic advantages over the developed world, such as higher gross domestic product growth rates and healthier demographic conditions are expected to persist for years to come. This is all encouraging, and a moderate level of emerging markets exposure makes sense for many long-term portfolios, but you should approach this asset class with your eyes wide open.
Enough exposure already?
The first thing you should do is determine how much emerging markets exposure you already have. The range of exposure international funds have to emerging markets varied widely, and some hold markedly higher stakes in that part of the world than others. As fund managers are buying more or adding to their existing emerging markets holdings, you may already have some exposure to the developing world, even if you don't own a separate emerging markets fund. You can find out your existing international share funds' emerging markets exposures by using Morningstar's Instant X-Ray.
Big risks as well as big rewards
If you want more emerging markets exposure, make sure that you fully understand the explosive nature and volatility of the developing world. This isn't the first time that emerging market offerings have outperformed--they soared in the rally between early 2003 and late 2007, for instance. Because of the dependence of many developing economies on commodity prices, and the sector concentration of most emerging markets, these strategies are extremely volatile and prone to sharp declines in unfavourable environments. They suffered much more than developed international share funds during the late 2007 to early 2009 global downturn, losing almost half of their value as demand for emerging markets materials and products sank and local conditions weakened. This was not an isolated incident, as many emerging markets strategies have suffered significant losses over numerous other periods during the past decade. Some emerging markets funds have been able to generate greater returns over the long term than UK equity funds but, at the same time, the emerging market funds' returns have fluctuated to a much greater extent. In other words, their returns have been substantially more volatile.
Choose wisely
Your first impulse may be to focus on the trendiest developing countries or offerings that leave their competition in their dust during rallies. A cautionary note: single-country emerging markets unlisted and exchange-traded funds are problematic. Single-country emerging market funds can't escape trouble in their chosen market and tend to be concentrated at the sector level, making them more susceptible to significant losses when conditions turn against them. Some regional strategies, such as those that focus on Eastern Europe, have weaknesses similar to those of single-country emerging market funds. (Those in the Asia ex-Japan category are an exception to this rule because of the number, size, and diversity of markets in their region.) And wider-ranging emerging market strategies that employ very aggressive strategies tend to blow up in tough times, as their styles exacerbate the already significant risks of investing in the developing world.
Finally, the extra upside of investing in the emerging markets doesn't always adequately compensate for the extra downside. And even when it does, the exceptional volatility of such strategies may end up being more than you can handle. The best course for most investors is to use a broad emerging markets fund--one which invests across the regions of the developing world--as a supplement to a fund investing primarily in the developed world regions of Europe, the United States, and Japan.
Zac Wallis is a Morningstar research analyst based in Australia.
