What are emerging markets and how do you invest in them?

In this article, we will explore the concept of emerging markets, discuss the benefits and risks associated with investing in them, and provide practical tips for investing in these dynamic economies.

What are emerging markets?

Emerging markets refer to economies experiencing rapid growth, which often exhibit significant potential for economic expansion and offer attractive investment opportunities. 

While there is no universally accepted definition of emerging markets, there are several generally accepted criteria for evaluating these markets:

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• GDP Growth Rate: Emerging markets typically exhibit higher GDP growth rates compared to developed economies.
• Market Capitalization: The size of a country's stock market is an important indicator of its potential as an emerging market.
• Regulatory Environment: Transparent and investor-friendly regulations are essential for a thriving investment climate.
• Liquidity: The ease with which investors can buy and sell securities in a market indicates its liquidity.
• Access to Capital: The availability of financing options and access to capital markets play a significant role in an economy's development.

Benefits of investing in emerging markets

Emerging markets often experience rapid industrialisation, urbanisation, and technological advancements, leading to increased productivity and rising incomes. As a result, companies operating in emerging markets can benefit from expanding consumer markets and higher demand for goods and services, and of course, better returns for investors from this faster growth. 

They may also provide diversification opportunities. Some markets, for example, Chile have large industries that can’t be found anywhere else (in Chile’s case its world-leading copper resources) and the performance of these markets may not be influenced by the same factors that impact developed countries. 

What’s more, it’s often the case these assets are trading at a significant discount to other stocks in developing countries. Therefore, investing in these assets at attractive valuations can result in significant long-term gains as their value is recognized.

As such, adding exposure to emerging markets can help reduce overall portfolio risk and potentially enhance returns.

Risks of investing in emerging markets

While emerging markets might offer some lucrative investment opportunities, they’re far riskier than developed markets. In some ways, investors have to accept this trade-off. Emerging markets are riskier than developed markets, but they also offer the potential for higher returns. Investors are compensated for the higher risk with higher returns. 

The main risk investors face in emerging markets is political. This includes government instability, changes in regulations, corruption, and geopolitical tensions. Political and regulatory uncertainties can significantly impact the business environment and investor sentiment, leading to increased volatility in the markets. 

Investors also need to consider currency volatility. Volatile currencies are a side effect of economic instability and uncertainty, a common feature of emerging markets. Fluctuations in exchange rates can affect the returns of investments, and investors need to consider how exchange rate changes will affect their investments. Once again, there’s a trade-off to be made here. Currency volatility might hit returns, but if one can earn higher returns overall, that might be a trade-off worth considering.  

Finally, investors need to keep an eye on market liquidity. Some emerging markets may have limited liquidity, making buying or selling securities quickly and at desired prices challenging. liquid markets can result in wider bid-ask spreads and increased transaction costs, potentially impacting investment returns. This could be another trade-off that’s worth dealing with due to the higher returns available. 

How to invest in emerging markets

Stocks and bonds  - Investors can directly invest in stocks and bonds of companies operating in emerging markets, although this is a high-risk approach. It requires thorough research on individual companies, industries, and the overall market conditions. This can be challenging in markets with different languages and regulatory environments to investors’ home markets. 

Exchange-traded funds (ETFs) - Mutual funds and ETFs offer a convenient way to gain exposure to a diversified portfolio of securities in emerging markets and are a good way to make a bet on an emerging market as a whole. These investment vehicles pool funds from multiple investors and are managed by professional fund managers. Investing through mutual funds or ETFs provides instant diversification and access to markets that may be otherwise challenging to navigate.

Private equity - Investing in private equity and venture capital funds focused on emerging markets can provide access to early-stage companies and high-growth sectors. Private equity and venture capital investments are typically long-term and involve actively supporting portfolio companies' growth and development. This approach relies heavily on the portfolio managers and depends on their experience in their local markets. 

Whichever approach you choose, it’s important to make sure you do your research, conducting extensive research on the target country's economic and political environment, industry trends, and individual companies. What’s more, spreading investments across different countries, industries, and asset classes can help mitigate risks and capture opportunities across a range of markets.

Investors also need to approach these markets with a long-term perspective. These economies may experience short-term volatility, but over the long term, they can potentially deliver significant returns. Investing in emerging markets requires patience and a focus on long-term goals. 

Regions such as India, Brazil and China have been the biggest growth stories in emerging markets over the past two decades, but their growth has taken decades to materialise and produce returns for investors. Investors who stayed for the ride, and focused on their long-term potential have been well rewarded. Those who didn’t and didn’t do their research might have jumped out at the first sign of trouble.