New Frontiers

In a previous column ("Across the Universe," 4/10/2007), I discussed the virtues of investing globally. That column focused on the developed world and largely ignored the stock markets in less developed countries, a section of the world commonly known as emerging markets. With globalization steaming ahead, let's take a look at emerging markets and see how (and if) they might play a role in your portfolio.

Question: What makes a country an "emerging market"?

Answer: The definition of an emerging market is often subjective and differs depending on your source. MSCI Barra's family of indexes (MSCI World, MSCI ACWI, etc.) is probably the best at identifying where a country falls. Without boring you to tears, MSCI Barra generally states that a country moves from an emerging market to a developed one when certain benchmarks are attained, including market accessibility, liquidity, geo-political environment, foreign exchange liberalizations and capital control issues. Currently, they consider 23 nations as developed– everyone else is an emerging market.

(Side note: For simplicity's sake, we'll lump emerging markets together as one category of stocks, though each country has its own strengths, weaknesses, concerns and idiosyncrasies.)

Question: What are some potential benefits to investing in emerging markets?

Answer: First and foremost, as the global developed markets become increasingly correlated and intertwined, investing in emerging markets provides an additional layer of diversification to your portfolio.

Perhaps more importantly, some of the risks traditionally associated with emerging markets began to dissipate in recent years. Private property rights—long the bane of emerging nations—greatly expanded, concurrent with a surge in democratic governments and increased investment in physical infrastructure such as schools, roads, and utilities. The overall financial landscape of these countries generally improved, as reflected in less restrictive lending and financing environments and a willingness to open borders to trade and investment from foreign lands. Large, multinational firms are making emerging markets a key part of their business—not just in terms of utilizing cheap labor, but also in selling goods and services to a rising middle class.

Question: How can I invest in emerging markets? How much of my portfolio should I invest?

Answer: There are many ways to gain exposure to emerging markets. Mutual funds are a good start. Actively managed funds focusing on emerging nations are readily available and can be found using a simple fund screener or talking to your broker. One caveat here is managed funds focusing on emerging markets tend to be expensive compared to other equity funds. Some will have expense ratios in excess of 2.0% or more. If you are fee averse, and/or if you prefer a passively managed fund, there are exchange traded funds and index funds that track some of the largest emerging markets indexes at a significantly reduced cost.

You can also invest in individual stocks, but be aware that emerging markets make up a very small portion of the global stock market (about 11%*). Unless you are investing a significant amount of money, diversifying 11% of your account in individual positions can be difficult (and expensive when you factor in transaction costs).

Because emerging markets are such a small part of the global stock universe, I wouldn't recommend allocating a massive amount of your portfolio to them. Last year, I explained why weighting a large portion of your assets to one sub-asset class relative to your benchmark is often a bad idea (see "Portfolio Construction," 12/20/06 for more).

Question: What kinds of risks should I be concerned about with emerging markets?

Answer: Although some risks commonly associated with emerging markets have abated, there are still points to consider. Many emerging nations still face challenges in terms of geopolitical tensions, economic instability and infrastructure.

China is a good example of a rapidly growing emerging nation facing significant challenges, despite robust growth in their GDP and in the price of Chinese equities. China's GDP (6% of world GDP**) has boomed over the last decade, largely due to increases in capital development, urbanization, and foreign investment; however, it still represents a small portion of the global stock market (<2%*). Plus, numerous inherent barriers keep China from commanding a seat at the developed nations table. Most issues center on the Communist government, which still has a hand in everything, including currency policy, foreign investment, modernization, and the stock market. A great summary of the challenges China faces can be found here.

China's Fabulous Moolah
11/5/2007

In summary, from ease of investment to attractive returns, emerging markets make sense as part of a well-diversified portfolio. However, I recommend educating yourself on the risks and remember the rules of benchmarking when considering your allocation.

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* Source: MSCI Barra, MSCI All Country World Index (MSCI ACWI)
** Source: International Monetary Fund