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Should You Invest In Emerging Markets

Are Emerging Markets worth your money?

Last Updated on November 16, 2020 by Daniel Woerle

Whenever you request guidance on how to invest to reach FIRE, you will often receive the comment you should invest in Emerging Markets e.g. through IWDA + EMIM. But should you?

First, we should define the differences between emerging and developed markets.

$0GDP
serves as cut-off between emerging and developed markets.

There are different approaches to distinguish between these two types of markets. Economic, political, and social aspects play a role, but also market size, structure, accessibility, and investment conditions influence the classification. Scientific research has shown “that a cut-off of $25,000 GDP per capita serves as an effective boundary between Developed and Emerging Markets” (Dimson et al., 2010).

Investing in Emerging Markets?

It’s almost always coined as a good diversification of your portfolio with the idea being it’s not a given, that the Developed Markets will keep posting solid growth. While the Emerging Markets posted solid growth in the early 2000s, these results might have been a one-off thing (Wall, 2016).

Dimson et al. (2010) stated that on average Emerging Markets only perform better than Developed Markets for a brief period, while in the long run they often perform far worse. In times of crisis, Developed Markets have outperformed Emerging Markets.

However, investing in Emerging Markets gives the illusion of being an excellent investment opportunity. We can still consider it a good diversification, but there might be a better way to do it than to just buy an ETF.

Emerging markets slowed down

Emerging Markets’ GDP increased by an average of 4,75 percent between 2000 and 2012. This pretty strong growth performance was fairly broad-based, with 60% of Emerging Markets having higher growth in the 2000s compared to the previous decade (Cubeddu et al., 2014). It’s clear Emerging Markets made great returns in the past decade. However, data shows both Emerging and Developed Markets had good runs with five decades a piece of our performance for each set of economies since the turn of the last century.

Experts hold the fast-paced globalization, especially at the beginning of the 21st century, responsible for this. However, this process slowed down after the 2009 financial crisis, which is why growth rates fell accordingly.

annual returns Emerging markets vs. Developed markets
Five decades a piece of outperformance for each set of economies since the turn of the last century.. Copyright https://www.morningstar.co.uk

In general, investing in Emerging Markets involves elevated risks than investments in Developed Markets. This is partly due to the fact that political decisions in Emerging Market regions are often subject to greater uncertainty.

While Developed Markets show positive performance and increasing political stability over longer periods, Emerging Markets are characterized by higher volatility. This mainly reflects the higher level of risks in investing in Emerging Markets in political and economic decisions and developments regarding the exchange and/or inflation rate.

Missing structural reform and education

Investing in Emerging Markets seems to be an uncertain business. Nevertheless, many investors are asking themselves: Should I invest in Emerging Markets?

There’s no obvious answer to this question. Rather, there is a trade-off between the pros and cons of investing in Emerging Markets. On the one hand, some Emerging Markets promise a high short-term growth rate and exceptional development potential, while on the other hand this is offset by a lack of investment in education and overdue structural reforms.

In Emerging Markets, the quality of education and infrastructure is far below the average level. Many of these countries cannot invest in human and physical capital to set the course for the economy in the right direction. Some Emerging Markets benefited from globalization and other external effects, such as good political networking before the financial crisis of 2009. The resulting productivity gains through economies of scale and worldwide networking flattened enormously in the crisis’s wake, while at the same time several economic stimulus measures designed to cushion the economic crisis failed to bear fruit or expired after too short a time. The result was shrinking economic growth in almost all Emerging Markets.

ProsCons
High short-term growth rateLack of educational investments
Development potentialMissing structural reforms

Emerging economies — China as a catalyst

China has been a key factor in the past growth phases of almost all Emerging Markets. It’s an incredibly large market, and enormous growth potential has ensured that China’s economic power has been growing. Various other Emerging Markets, such as Brazil, Chile, or Congo, also benefited from this as suppliers of raw materials for the construction and expansion of infrastructure. In the meantime, almost the entire western part of China is now well embedded in the national infrastructure, which is why the volume of these types of investment has fallen.

China was thus the decisive factor and catalyst for the last three growth cycles, 2009/10, 2012/13, and 2016/17 of the Emerging Markets. Many other countries and regions took advantage of this to strengthen their economy. Today, however, China is investing more in modern and high-tech goods and services, most of which do not originate from the Emerging Markets, which has caused their economies to shrink.

However, China’s economic activities also have their downsides. China’s national debt, for example, has risen from around 20% of GDP at the end of the 1990s to just under 35% in 2009 and even to over 50% by 2018. And all this despite solid economic growth. Also, the simple and effective equation: investment = growth, no longer quite corresponds to reality. For example, the amount of capital needed to generate every additional unit of Chinese production has risen by almost 70% since the beginning of the 21st century.

The ongoing trade war between the USA and China is not helping to ease the situation. On the contrary: the risk of the Chinese market remains, and sometimes is even increasing. More and more, American investors, are leaving this segment, at least temporarily.

Investing in publicly traded export-oriented companies? — IWDA + EMIM

There are many arguments against investing in Emerging Markets. The risks of investing in Emerging Markets keep many people away from them. Nevertheless, there are a few possibilities to do so with reduced risk of overexposure.

A recent study by Bae et al. (2019) Suggests an alternative way of investing in Emerging Markets: invest in developed-market stocks that do a lot of business there. They even made their own index to mimic this. However, due to the inherent risk involved with EM, their risk-adjusted return is horrible. the main problem with this idea is execution. To execute this strategy you’d have to do a lot of manual work as it’s not poured into a fund or tracker (yet?).

Without a specific ETF focussing on this strategy, what else is there left to do?

iShares Core MSCI EM IMI UCITS ETF

Perhaps the best way to invest in Emerging Markets is the iShares Core MSCI EM IMI UCITS ETF managed by Blackrock. It is one of the largest of its kind, with over 15 billion USD in assets under management. It specializes in Emerging Markets and has important and stable companies from emerging regions in its portfolio. Alibaba and Samsung, 2 highly internationalized and networked companies, are part of this ETF.

In 2019, for example, the U.S. shares in the MSCI ACWI Index were 54%, with a total U.S. share of 24% of global GDP, while Chinese companies only held shares of 3.7% in this index. Although the Chinese economy accounts for approximately 15% of the global GDP. It is quite clear that American companies are overemphasized and Chinese companies are even more under-represented. However, this circumstance will fade. Experts assume that Chinese corporations will hold larger shares in such indices in the future. The increasing economic growth and the growing importance of China in the world are contributing significantly to this. By investing in emerging markets, such as the Chinese ones, can also promise in the long term here (Ralston & Mee, 2019).

Many investors combine MSCI Emerging Markets ETF with iShares Core MSCI World UCITS ETF USD, which favors companies from Developed Markets and thus combines the best of both worlds, Developed and Emerging Markets.

If you still wish to invest in Emerging Markets, I’d regard this ETF as particularly interesting. Some of the most promising tech companies from the United States have their shares in this one.

VWCE

An alternative without any hassle is VWCE (Vanguard FTSE All-World UCITS ETF USD Accumulation (EUR)). This tracker follows the market-capitalisation weighted FTSE All-World Index enabling you to invest in EM in a diversified and straight-forward way.

Sources:

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Mr. FightToFIRE

I'm the owner and the main writer of FightToFIRE, a personal finance blog focussing on Financial Independence and Retiring Early. During the regular working hours, I'm a developer for a major financial institution in Belgium. During my off-hours, I write. do some weight lifting and other stuff to keep me healthy and fit.

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