Emerging markets ETFs and index funds are high risk, high reward investments. They certainly haven’t been kind to investors lately. But it doesn’t have to be, if you understand the risks. While most are thinking its time to cut and run, it might be a reason to buy.
There are three ways to invest in emerging markets: buy stock in a local company doing business overseas, you can buy a foreign company through its ADR or American Depositary Receipt, or you can buy a diversified emerging markets ETF or index fund.
What Are Emerging Markets
You won’t find developed countries in these funds. Rather, emerging market economies are going through major industrial growth. Think of it as their own Industrial Revolution. New businesses are growing, infrastructure is being built, education levels are rising, and these countries are in the process of growing a middle class that brings higher wages and discretionary spending.
The big four emerging markets are referred to as the BRICs: Brazil, Russia, India, and China. But there are emerging countries in Latin America (Mexico), Asia (Indonesia), Eastern Europe (Turkey), and parts of Africa.
These countries are growing two to three times faster than any developed country. That means businesses and profits in those areas are growing faster. This is why you see higher average returns from an emerging markets fund.
These countries don’t move together, as this table shows, because each has its own risks from year to year.
The Risks
On top of the typical investment risks you get with a U.S. company or index fund, emerging markets have extra risks to consider.
- Political Risk – political instability, lack of securities regulation, limited accounting standards, and government-run businesses and business seizure are the big concerns.
- Currency Risk – if you’ve traveled overseas you know that currency exchange rates change daily. Your investment is affected by movements in the exchange rate between the dollar and the local currency. If the U.S. dollar rises against the local currency your investment falls in value. Alternatively, the investment value rises, when the dollar falls. All of this happens on top of the regular changes in stock price.
Even the typical risks are heightened when an economy grows at a fast clip, especially inflation, liquidity, and default risk. It’s all affected by global changes too. Little changes in developed economies have a big impact on the global flow of money. It trickles down to hit the performance in emerging markets.
Because of these added risks, its best to stay diversified and invest in an emerging markets ETF or index fund. Of course, understanding these risks will help you see opportunities that others don’t.
Best Emerging Markets Funds
There are a number of funds to choose from, but you can whittle down your choices with a quick ETF screen for Emerging Markets and start with the lower cost funds. Here are the better Emerging Markets ETFs available:
- Vanguard FTSE Emerging Markets ETF (VWO) – is an index ETF that tracks the FTSE Emerging Index which tracks stocks of companies based in emerging markets around the world.
- iShares MSCI Emerging Markets Index Fund (EEM) – this fund invests in stocks of companies in emerging markets that are tracked by the MSCI Emerging Markets index.
- WisdomTree Emerging Markets High-Yielding Equity Fund (DEM) – this is a fundamentally weighted index fund by dividend yield. It selects the top 30% highest dividend yielding stocks in the WisdomTree Emerging Markets Index.
Of course, you can take this a step further and invest in a specific country, but that’s not without its risks either. I’d suggest extra research before investing.
Conclusion
Like any economy, emerging markets grow in waves that slow down and speed up over many years. It’s not like setting a cruise control, it never grows at a fixed rate. So the best time to invest would be right before these economies pick up speed again. Anytime the risks become reality, the value of emerging markets funds will fall. While there are several reasons these funds drop in value, it usually signals a long-term buying opportunity.
