Too embarrassed to ask: what is an emerging market?

This week's “too embarrassed to ask” explains what emerging markets are, and why you might want to invest in them.

When it comes to investing, countries are split into two broad categories: “developed markets” and “emerging markets”. Developed markets are mostly the ones you’d expect – wealthy, advanced economies with large, well-regulated financial markets. The UK, the US and Japan are obvious examples.“Emerging market” meanwhile is used to describe countries that are becoming wealthier and more economically advanced, but which are not yet classed as developed economies.

The most influential bodies in deciding on a market’s status are the index providers – the companies who compile and calculate stock market indices, such as MSCI or FTSE Russell.

As with many terms in investment, however, there is no universal definition of what exactly separates an emerging market from a developed market.So some countries – such as South Korea – might be viewed as emerging markets by one provider, and developed by another.

Index providers don’t just look at economic development. They also take into account the size of local financial markets, and how easy it is to trade in and out of them.For example, most Gulf nations are classed as “emerging markets”, despite having high income per head, because their markets are smaller and less easy to invest in than those in developed markets.

A country can also move between the categories. For example, in 2013, as a result of the eurozone sovereign debt crisis, most index providers moved Greece from “developed” to “emerging” market status.

Another term you may encounter is “frontier markets”. These are developing economies that have not yet reached emerging status.While some of these countries are much poorer than those in the emerging markets index, others – such as Vietnam – are classed as frontier markets only because they impose restrictions on foreign investors.

Why might an investor want to have exposure to emerging markets? Investing in these nations tends to be riskier. However, they also tend to be faster growing.The idea is that investors will be rewarded for taking this higher risk with higher returns.As always though, it makes sense to diversify. For more on the best ways to invest in emerging and frontier markets, subscribe to MoneyWeek magazine.

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