Should You Invest in Emerging Markets?

As some developed markets like the US face record high valuations, many investors are looking elsewhere for investment opportunities.

Some investors are considering emerging market investments, due to the potential of high returns from rapidly growing economies, and for diversification. However, with the prospect of high returns come the potential for higher risk.

Are investing in emerging markets right for you? This guide breaks down what you need to know before making a decision.

Before answering this question, it is helpful to understand the general classifications of investable markets, of which there are three primary categories:

• Developed Markets: are those we consider to be advanced and wealthier countries such as Japan or Canada.

• Emerging Markets: are those somewhere in the middle that are well on the journey to becoming fully developed countries such as China and India.

• Frontier Markets: are countries that are still quite economically undeveloped such as Pakistan or Vietnam.

These designations reflect from most to least the level of economic, social and political development of their respective countries.

In fact, there is no definitive definition of an Emerging Market, instead, various organisations make their own classification.

For example, S&P uses various qualitative and quantitative criteria in combination with their assessment of the views of the investor community to determine whether any particular country is an Emerging Market.

In a globalised world, Emerging Markets benefit from all the knowledge and capital already created by the fully developed countries. Consequently, well-run Emerging Markets can develop their economies at a much faster pace than developed countries.

As they are relatively underdeveloped, there are many opportunities for businesses and individuals to invest, taking advantage of relatively lower labour costs, expanding the production of local resources, or pursuing some other relative economic advantages.

For these reasons, at least at first glance, emerging markets offer an exciting investment proposition.

Emerging Markets can have unstable or inequitable political, legal and economic structures. Such flaws in their social fabric can lead to worse economic outcomes both for the citizens of their countries, but also for investors such as you!

Consequently, emerging markets are riskier than developed markets.

In many classifications of emerging markets China and India feature heavily – as indeed they should, as they represent roughly 35% of the world’s total population combined.

If either of these countries should experience economic or geo-political instability, then this could have a significant impact on the value of a typical emerging markets portfolio.

One index that measures Emerging Markets is the S&P Emerging BMI Index.

As can be seen in the chart below, over the last twenty years Emerging Markets have produced a somewhat lower performance than Developed Markets as measured here by the MSCI World Index.

Notably Emerging Markets produced an impressive performance from 2004 to 2007, outpacing Developed Markets (MSCI World) significantly (40.04% vs 18.19% in USD). However, since then, Developed Markets have generally performed better.

In particular, these returns have been mirrored by the relative performance of China. To illustrate this, below is a chart of the Shanghai 300 index where this market produced spectacular returns in 2006 and 2007 yet has only exhibited slow growth subsequent to the Global Financial Crisis.

What comes next for Chinese equities is anyone’s guess, but what we can be almost sure of is that China will continue to be an ever larger player on the world stage and its economy will continue to develop.

A more recent history of the primary constituents of the S&P Emerging BMI Index is shown below (in USD). We can see that Taiwan and India have produced the strongest returns, and Brazil the least.

Correlation measures how closely two investments move in relation to each other, expressed on a scale from -1 to +1:

• +1 correlation: Two investments move in perfect sync (e.g., two S&P 500 index funds)

• 0 correlation: Two investments move completely independently (e.g., a small private business and foreign currency markets)

• -1 correlation: Two investments move in opposite directions (rare in practice, but bonds and stocks sometimes approach this)

A low correlation can be great for a portfolio as it can help smoothen the ups and downs of your investments.

If you invest in the Kernel Emerging Markets Fund, it will aim to track the S&P Emerging BMI (NZD) index.

This index tracks companies listed in 23 emerging countries as designated by S&P most notably: China, India, Taiwan and Brazil. To be included in the fund companies must meet certain minimum size and other criteria.

The S&P Emerging Markets BMI Index holds a diverse sector weighting, this is illustrated in the figure below.

Compared to the MSCI World, Emerging Markets have a greater exposure to Financials, Materials and Consumer Discretionary and a lower exposure to Health Care and Tech as shown in the figure below.

A significant portion goes to major economies like China and India, with smaller amounts in countries like Brazil and those of South East Asia. Below we can see the exposure breakdown by country.

Emerging Markets can be a great additional part of your investment portfolio, but they're not for everyone. Here's what to consider:

• Potential for high growth

• Exposure to rapidly developing economies

• A means of diversification of your investments

• Potential volatility

• Geo-political and social risks

• Currency risks

Emerging Markets fit naturally into a core-satellite investment strategy. While your core portfolio might consist of Developed Market funds providing stability and predictable returns, Emerging Markets can serve as an effective satellite holding.

Their lower correlation with Developed Markets makes them a useful addition for diversification, while their growth potential offers the possibility of enhancing overall portfolio returns.

Consider starting with a small allocation (5-10% of your portfolio) and adjusting based on your risk tolerance and investment goals.

The key is to maintain a long-term perspective and resist overreacting to short-term volatility. Remember that Emerging Markets are just one component of a well-structured portfolio – usually, they would complement your core holdings rather than dominate them.

This approach allows you to participate in Emerging Market growth opportunities while maintaining the stability of your core investments in more established markets.

Emerging Markets offer exciting opportunities for investors willing to accept higher risks for potential higher returns.

While they've shown they can deliver strong performance, they require patience and a stomach for market swings.

Want to learn more? Check out the fund below.