While there’s no place like home, the U.S. stock market’s recent gyrations have many investors ready to look overseas for better returns. But while more experienced individuals might be ready to jump into emerging markets, many rookie investors are timidly sitting on the sidelines, wondering: Should they or shouldn’t they?
Here’s what you need to know make investing in emerging markets a little less scary.
Start with a history lesson. Learn what you can about the regions of the world that have done well over the past five years, and see what experts are saying about their prospects going forward. Find out about what industries are doing well in these regions. Of course, that’s just the beginning.
Brush up on your current events and watch the headlines. Emerging market investments are known for their volatility, and in less stable regions, local politics can have an out-sized effect on returns. However, while you want to know what’s happening, you don’t want to “chase the news, particularly the good news,” says Adrian Cronje, chief investment officer at Balentine.
For example, Brazil is raising its primary fiscal surplus target to 3.4% due to higher than expected revenues. “Yes, Brazil is actually running a surplus: Its government spends less than it takes in through taxes,” says Charles Sizemore, editor of the Sizemore Investment Letter. “Meanwhile, Portugal is having a difficult time balancing the books. The country just announced the biggest budget cuts in 50 years, along with a string of new taxes on capital gains and business profits.”
Although inflation is starting to pop up again in some countries, emerging markets as a whole are enjoying price stability previously only dreamed of, says Sizemore.
Emerging markets are likely to produce much stronger growth than developed markets over the next several decades, says Ron Weiner, president of RDM Financial Group. They currently trade at attractive historical valuation levels (going back to 1990 based on MSCI data), and their consumers and governments are not burdened by the high debt levels of developed countries. According to research from Goldman Sachs, GDP in the BRIC nations alone — Brazil, Russia, India and China — could represent 50% of global GDP by 2050, he says.
It’s important to remember that the idea of “emerging markets” covers a wide range of nations, each of which may behave very differently from an economic perspective, despite a growing trend of globalization, says Heiner Skaliks, portfolio manager of Strategic Latin American Fund (SLATX). Last year, the Peruvian market had returns of close to 70%, while Brazil had returns of 6% and Russia had returns of approximately 21% (in U.S. dollar denominated terms). Since the beginning of the year, these markets have had losses of 13%, 21% and 4% respectively, but in the last 30 months averaged gains of 58%, 129% and 44% respectively, says Skaliks.
Don’t Bet the Farm on One Emerging Horse
“It is important to remember that just like any other investment, it is impossible to predict the growth of any country,” says Mark Matson, CEO of Matson Money. “Be cautious and don’t concentrate all of your assets in one area.”
Likewise, don’t concentrate all your money in one asset class: Foreign markets offer more than just stocks. Emerging market bonds (including local currency denominated, inflation indexed, and also corporate securities) are an asset class growing in size and — if handled correctly — can help you diversify your portfolio, points out Cronje.
Both emerging market stocks and bonds are risky asset classes, but they’re becoming less volatile as investors increasingly come to see the relatively stronger macroeconomic conditions in emerging market countries — less debt, better demographic trends, more policy options available — as positives amid these in troubled times for the developed world, says Cronje.
Then too, certain emerging stock and bond indexes are quite concentrated in a small number of countries, says Cronje. Be sure you know what you’re getting.
What to Watch Out For
Weiner of RDM Financial says he worries about three things: “A continued rise in inflation that causes central banks to have to increase interest rates more aggressively; a substantial slowdown in the global economy that hurts emerging market experts; and an increase in investor risk aversion that causes money to come out of emerging markets.”
Though it’s a warning that applies in developed markets too these days, be wary of political risks. For example, Venezuelan President Hugo Chavez recently announced plans to nationalize the country’s gold industry. These things happen in politically unstable countries, says Sizemore.
Beware of export-focused countries, he cautions. Given that the United States and Europe are weak right now, you don’t want to invest in emerging market companies that primarily export to them. You want companies that sell to a healthy domestic middle class, says Sizemore.
Realize too, that the opaque accounting practices common in less well-regulated nations mean the possibility of less-than-useful information on the balance sheet, says John Graves, a principal with The Renaissance Group. Weaker legal protection can cause liquidity to dry up quickly in a company, a market or a region. “Funds or ETFs are not immune to these problems,” says Graves.
How to Play the Game
How much you should bet overseas depends partly on your age, and partly on your ability to sleep well at night with your money in an asset that class that can be highly volatile, says Weiner. However, having between 10% and 15% of the equity portion of your portfolio in emerging markets probably makes sense in the current environment — with the caveat that you should look at this part of your portfolio strictly as a long-term bet, says Weiner. “We believe that emerging market debt denominated in local currency could be as much as 10% of a fixed income portfolio.”
Whether you’re picking individual stocks or investing through a mutual fund, keep track of the sectors you’re investing in. Some sectors, like energy and mining, are driven more by global factors and less by local ones. “For example, if you want to invest in, say, the rise of the Chilean or Peruvian middle-class consumer, you don’t want to load up on copper miners, which make up a large part of both countries’ stock markets,” says Sizemore. “You’re wanting exposure to the new middle class and its spending, not to the volatile price of a particular metal.”
And that middle class will grow rapidly. “The World Bank projects that 800 million ‘middle income’ consumers will join the world economy by 2030, with developing markets accounting for 93% of the global middle class by 2030,” says Weiner.
“Avoid currency speculation as a newcomer, you will be eaten alive,” warns The Renaissance Group’s Graves. Instead, he recommends sovereign bonds as a good place to start, purchased through an exchange trade fund. ETFs are also an inexpensive alternative to global funds which, at more than 1.5% for annual expenses, “can be quite dear to own,” he notes.
Cronje says currency appreciation will be an important part of returns from emerging market exposure in the future. “Emerging market local currency bonds are therefore an important opportunity to consider.”
Sizemore is big on emerging market mutual funds and ETFs with a consumer focus. He recommends the Emerging Global Shares Dow Jones Emerging Market Consumer Titans Index Fund ETF (ECON).
You can create a short list of foreign stocks at finviz.com, advises Graves. “Use a stop-loss on any purchase, either here or overseas,” says Graves.
You can also focus on multinational U.S. and global companies that sell goods and services to emerging markets.
Mirror the Pros?
If you’re not sure of your own abilities to swim successfully in emerging markets, you might want a lifeguard of sorts looking out for you.
Covestor, an asset management firm and registered investment adviser, offers a wide selection of emerging market models managed by experts. “Replicating the trades of a seasoned emerging markets investor through Covestor or another mirrored investing firm is a good way for people to gain experience investing in emerging markets,” says Kalen Holliday, a spokeswoman for Covestor.
Being globally diversified is essential to any healthy long-term oriented portfolio, and investing in emerging markets is a great move in that direction, says Matson.
“Start small, give yourself a long time horizon and be protective of your risk,” suggests Graves. “Allow many small errors, look for the good opportunity: Dividends are key.”