Know the details before investing in emerging markets stocks

In a year of robust stock market gains – performance that has disregarded the chorus from analysts and advisers to prepare for lower returns – emerging markets stocks have posted the highest marks.

The MSCI Emerging Markets Index was up 25.8 percent in U.S. dollar terms year-to-date through the end of July when including dividends.

This outperformance of U.S. stocks (the S&P 500 was up 11.6 percent year-to-date through July 31) isn’t a surprise. Measures of valuation had pointed to these foreign stocks trading at less expensive prices than U.S. stock indexes.

While a lot of new investment has moved into emerging markets stocks over the past year, many people still do not participate.

Employer retirement plans are the primary investment vehicle for most people and many company plans do not include an investment choice for emerging markets. This is true for many corporate plans and for the federal employee Thrift Savings Plan.

This means that to gain exposure to emerging markets, these investors must invest in an account other than their employer plan such as an Individual Retirement Account (IRA) or brokerage account.

But before you decide to add or increase emerging markets exposure, you should understand the characteristics of this segment of the market.

Performance is only one element of the equation that indicates how much, if any, exposure you want to have. Especially in emerging markets, risk should carry as much influence as return potential.

While emerging markets stocks have posted big gains this year, their average annual return over the past decade is less than 2 percent because of some deep negative stretches.

What is an emerging market?

Nearly two dozen countries with economies and stock markets are less mature than the “developed market” countries. Most of the emerging markets nations are in Asia and Latin America. China and India draw the most attention.

If you look at the top 10 companies in the MSCI Emerging Markets index, you likely won’t recognize more than one or two names. This doesn’t fit well with the common recommendation to “buy what you know.”

With so many investment choices you know more about, why would you want to add emerging markets and unknown companies to your portfolio?

Consider that more than 4,000 of the world’s publicly traded companies are listed on emerging markets exchanges. That’s more investable companies than in the United States in a part of the world with more robust economic growth.

The investment opportunity in these countries is heavily weighted toward financial and technology stocks. Partly due to concentration in two sectors, but also because of geopolitical and currency reasons, emerging markets have historically been more susceptible to volatile economic events and stock market performance.

According to institutional investment manager GMO, individual emerging market countries have fallen more than 20 percent an astonishing 22 times since 1990. This is compared to four such experiences for the U.S. S&P 500.

Because of this volatility, the recent GMO white paper concludes that “clearly a ‘buy and hold’ strategy for the broad asset class is not the right approach.”

But it also notes that “we believe risks are significantly lower (currently) and valuations are fair.”

How to invest in emerging markets

Once you decide you want emerging markets included in your investment strategy, you need to determine how much exposure is preferable.

This is an investment that should likely be a small satellite, rather than a core piece of your strategy.

Emerging markets comprise about 10 percent of total global stock market. A globally balanced investor with a 60 percent stock portfolio would have about 6 percent in emerging markets if they wanted to mimic market weight.

This is too much for most investors, however, given the large downside potential and difficulty timing when to be in or out of emerging markets.

You could buy a broad index fund and capture all the emerging markets at one low cost. But each individual emerging markets country is quite different. Latin America could be weak or strong while Asia is the opposite. This might be a slice of the market where a more adaptable strategy could be beneficial.

Even if you don’t buy stocks of companies headquartered in these countries, you could participate in the growth of emerging markets by owning U.S. stocks. They buy Coke, iPhones and Nikes in emerging countries too.

But you would miss the share of profits and innovations that come out of the companies based in these countries and traded on local exchanges.

Your portfolio might enjoy a boost in potential return, just don’t overdo it chasing what’s been hot.

This story was originally published August 5, 2017 at 5:54 PM with the headline "Know the details before investing in emerging markets stocks."