What is an emerging market? It’s a question most investors will ask at some point, given how often the term is used.
After all, understanding what you are investing in is absolutely vital, while spreading your risk across different assets ‒ and with it different markets ‒ is an important tactic for any investor looking to protect their portfolio.
So what do we mean by ‘emerging markets’?
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What is an emerging market?
Emerging market is a term used to describe countries which are not yet classed as being developed.
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.
Meanwhile, the term emerging market is used to describe countries that are becoming wealthier and more economically advanced, but which are not yet classed as developed economies.
Who decides what counts as an emerging market?
The most influential bodies in deciding on a market’s status are index providers– the companies that 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. 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.
Can countries move between developed markets and emerging markets?
A country can also move between the categories of developed market and emerging market.
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 invest in emerging markets?
Investing in emerging markets is an important consideration for all investors.
While these markets are naturally riskier, this is offset by the fact that they also tend to be faster growing. The idea is that investors will be rewarded for taking this higher risk with the potential to enjoy higher returns.
What’s more, there is also the fact that investing some of your portfolio in emerging markets helps you diversify, opening up the potential to see some sort of growth even if the developed markets go through a sticky period.
For more on the best ways to invest in emerging and frontier markets, subscribe to MoneyWeek magazine.
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