Did you know that in 2019, emerging markets economies accounted for 74% of global economic growth and are forecast to contribute 84% by 2023? And in stock market investing, emerging markets have historically outperformed developed markets. It’s not just a great way to tap into growth markets, but it also helps you to increase your portfolio diversification.
In this article, we will look at 5 reasons why investing in Emerging Markets could pay out in the long run. And at the very end, I will also show you 3 simple ways how to invest in Emerging Markets yourself.
Explanation of Emerging Markets
Before we jump into it, let’s quickly have a look at what Emerging Market actually mean. These are countries that are between the stages of developing and developed countries. One key feature that most emerging market countries share is fast economic growth, specifically GDP growth. And although the term “Emerging Markets” is used very often in investing, there is not a closed and definite list of countries.
What you will often see though is this list of countries, which includes the BRIC, the CIVET, and a dozen of other countries. But why would you invest in emerging markets in the first place? And that brings us to Emerging Markets opportunity number 1
1. Changing world order
Historically, global powers changed quite a lot. Time after time, there will be a new rising power that will challenge the existing power. And with increased global power comes the domination of the global stock market. If we look at the US, their share of the global stock market is around 60%. But what does “global power” mean? Ray Dalio actually looked at this and visualized 8 key powers:
These are education – which picks up first – technology, competitiveness, military, trade, economic output, financial power, and what comes last is the reserve status. Now, what does it have to do with Emerging Markets? Well, there is one new rising global power that could replace the US in the next few years to come. And that is currently an Emerging Market country.
To be more specific, it’s China. If we look at their past power ranking, we can see how their power ranking went down from the year 1500 until it reached its bottom in 1950. And since then, it’s shooting up like a rocket again. And at the same time, we can see how the US reached its peak around 1950, and since then it’s slowly going down.
So the two nations are currently moving in the opposite direction. And looking at the momentum, it will only be a matter of time until China will take that number 1 spot again. This could be a great opportunity to be invested in a country early on before it takes the number 1 spot in the world. That brings us to Emerging Markets opportunity number 2
Over a decade ago, emerging market overtook developed countries in terms of economic growth. Today, they account for close to 60% of the global GDP. China alone makes up 20% of the global GDP, up from 2% in 1980. The world is changing! And it is likely that this growth will continue because developed countries are struggling more and more to keep up with growth rates.
Another source of GDP growth is population growth. Emerging markets currently make up 86% of the global population. They have a younger population that is just waiting to move into the middle class, consume more goods and services, and ultimately increase their country’s GDP and the value of their companies. If you look at China’s development since 1978, for example, their GDP per capita went up by 25x.
The poverty rate in 1978 was 96% – today, it doesn’t exist anymore. Life expectancy went up by 11 years. And Average years in education have doubled since 1978. Investing in Emerging Markets can also be a great way to diversify your portfolio. And that brings us to Emerging Markets opportunity number 3
3. Low Correlation to Developed Countries
According to Allianz Global Investors, Emerging Market stocks had a correlation of 0.69 with global equities over the last 10 years. It means that Emerging Market stocks moved in different directions compared to global stocks 31% of the time. Just as a comparison: the US and global equities had a correlation of 0.97, which means that they only moved in different directions 3% of the time. Investing in uncorrelated assets can increase your diversification.
If one asset goes down, then the other one has a good chance to move up. And the probability of this increases if you own assets with little to no correlation. And that brings us to Emerging Markets opportunity number 4
4. Undervalued and under-allocated
We looked at many of the benefits that emerging markets have. But still: The valuation gap between developed and emerging markets keeps getting bigger and bigger. The MSCI Emerging Markets index, for example, which is a proxy for Emerging Markets stocks, trades at a 27% discount to the MSCI All-Country World Index and a 40% discount to US stocks if we look at the forward PE ratio.
This undervaluation is combined with an under-allocation into Emerging Markets by the average investor. Emerging markets today make up 86% of the global population, and 58% of the global GDP, but only have a weight of 15% in the MSCI ACWI – BlackRock’s All-Country World ETF. Even worse: The average global investor only holds around 6-8% in emerging markets stocks. Part of the reason for that under allocation is that Emerging Markets have disappointed in terms of stock market performance in the last 10 years.
But we will get to the performance side in just a second. The bottom line here is: Many investors may be missing out on the long-term potential of emerging markets stocks by not being invested in them. Investing in Emerging Markets comes with higher volatility and risk. In theory, taking on higher risk in the stock market should give you a risk premium. And that brings us to Emerging Markets opportunity number 5
5. Higher returns
But how did Emerging Markets actually perform against US stocks in the last 10 years? Let’s have a look. In red, we have Vanguard’s Emerging Markets Stock Index which is a proxy for Emerging Market stocks and in blue we have Vanguard’s Total Stock Market Index which is a proxy for US stocks. And you can immediately see how badly Emerging Markets performed against US stocks with an annual return rate of only 4.4% per year – over 10% lower than US stocks.
In fact, in the last 10 years, Emerging Markets had their worst performance ever. But that’s also what you need to be aware of: You are investing in more volatile and risky assets. That’s why a long-term focus is key. If we zoom out and have a look at the performance since 1999, so before the Dotcom Bubble, then you can see that Emerging Markets have actually outperformed US stocks with an annual return rate of over 8% per year.
So if you have a long-term focus and if you are patient enough, you could be rewarded with a higher return. Our goal on this website is to give you guys a balanced view of things.
So big disclaimer here: Investing in Emerging Markets comes with risks! In the long run, they “can” get you higher returns. But temporarily, there could be times of volatility and low returns. And when you have years or decades without higher returns, it’s just all risk that you are taking on. The next risk is a lack of transparency.
Emerging Markets Risks
Accounting standards for Chinese, Indian or Brazilian companies are not the same as in the US or Europe. There is always the risk of numbers being inaccurate or inflated or even completely made up. That’s why you have a lot of accounting fraud cases in China, for example. One example here is Luckin Coffee. They inflated their sales numbers by 88% and when this came out, their stock price fell by 97%.
Another factor is political risk. There is a higher chance of government interventions or political instability. A recent example here would be the Chinese government tightening regulations on Alibaba and other tech stocks and the gaming sector, which send the Chinese stock market down.
And then there is an economic risk. Emerging Market countries are more likely to see inflation, FX risks, and unstable monetary policy. So yes, there are huge opportunities in Emerging Markets but also some big risks that you should be aware of.
How to Invest in Emerging Markets
You understand the opportunities and risks and you still like the idea of investing in Emerging Markets? Then the next question is: How do you invest in them? You could do stock picking. But another, much simpler and more effective way to invest in Emerging Markets is through ETFs. One option that you could go for is Vanguard’s FTSE Emerging Markets ETF, ticker symbol VWO.
This ETF invests in large-, mid-, and small-cap stocks from 23 Emerging Market countries. It’s one of the largest, most liquid, easiest, and cheapest Emerging Market ETFs out there. That’s also the reason why the VWO is used by Ray Dalio and his investment firm Bridgewater Associates, the largest hedge fund globally. It’s actually the third-largest position of Bridgewater, making up 4.8% of their total portfolio.
The next ETF that we are looking at is the best performing Emerging Markets ETF of the last few years: The Emerging Markets Internet & Ecommerce ETF, ticker symbol EMQQ. This ETF only includes Emerging Market companies that get more than half their profits from e-commerce or internet activities. And these activities include online search, retail, social networks, video, gaming, and e-payment systems.
So the EMQQ captures both, emerging markets growth and digitization. And despite the Chinese Tech stock crash a few months ago, this ETF managed to grow by 14% per year in the last 5 years, outperforming the majority of Emerging Markets ETFs.
And last but not least an option for investors that want to combine ESG with Emerging Markets investing: The iShares ESG Aware MSCI EM ETF, ticker symbol ESGE. This fund tracks the MSCI Emerging Markets Extended ESG Focus Index. And it tries to maximize its exposure to stocks with high ESG ratings. For that, it uses BlackRock’s second strongest ESG filter. But hey – question to you: Do you actively look for ESG-screened stocks or ETFs? Or do you only care about your returns? As always – Let me know in the comment section below!
There you have it: 5 Emerging Markets opportunities that could pay off in the future. Investing in Emerging Markets also comes with big risks obviously. But higher risk also comes with higher opportunities. But what do you actually think? Are you holding your Emerging Markets or do you believe in the US and Developed Markets stocks only? As always: Let me know in the comment section below.
DISCLAIMER: This article is for educational purposes only and merely cites my own personal opinion. In order to make the best financial decision that suits your own needs, you must conduct your own thorough research and seek the advice of a licensed financial advisor if necessary.