Investing in emerging markets. Is it worth the risk?
With hazards that are bigger and more numerous, these markets highlight the importance of diversification.
The road to successful investing in emerging markets is littered with potholes, speed bumps, and tolls. The risks facing investors in these markets are many and acute.
Over the 10 years through February 2022, the standard deviation of the MSCI Emerging Markets Index was 20% higher than the MSCI World Index (a proxy for global developed-markets stocks). But traditional measures of risk don't adequately capture the myriad risks present in developing markets, which range from poor governance to political strife. Nor do they scale the trading costs and taxes involved in gaining access to these markets.
Russia’s recent invasion of Ukraine, and the subsequent responses from governments around the world, are among the latest risks to have an impact on emerging-markets funds. As of this writing, governments have imposed a range of economic sanctions on Russia. But the effect on financial markets is far more complicated. The Moscow Exchange remains closed, while exchanges in Europe and the US have halted trading in some locally listed depositary receipts of Russian companies. Investors that want (or must) sell these assets may not be able to--and in the event they can, those trades will come with hefty losses.
While not ideal, the impact on investors in broad emerging-markets funds should be limited, as Russian stocks and bonds represent a small fraction of the affected portfolios. But it serves as a reminder that emerging markets face incremental risks, as this historical montage demonstrates.
Corruption and political influence
One of the most recent and prominent examples of corruption in emerging markets came to light in late 2015. Executives at Brazil's state-owned oil company Petrobras (PBR) were caught in an intricate web of bribes and payments between the company's contractors, executives, and Brazilian politicians. The scam drained money from the company while enriching the parties involved, including Brazil's former president Luiz Inacio Lula da Silva, who subsequently went to prison.
Harmful actions by crooked executives at emerging-markets firms are anything but novel. Russia was rife with these situations in the late 1990s as its economy attempted a transition to a capitalist democracy. In late 2000, investors discovered that Gazprom, Russia's state-owned natural gas behemoth, had sold off several major natural gas reserves to insiders, including its own executives and their families, at pennies on the dollar.
Both firms have another distinguishing feature that increases risk. Petrobras and Gazprom are examples of state-owned enterprises: companies that are partially or largely owned by their respective governments. State ownership is far more prevalent in emerging markets than developed economies. You'd be hard-pressed to find state-owned firms in many developed countries, while estimates indicate that they account for a bit more than 20% of the MSCI Emerging Markets Index*.
State ownership increases risk because politicians' agendas don't always align with investors' interests. Corporations typically have a narrow objective of maximizing profits for shareholders, while governments' responsibilities include resource security, foreign policy, and social welfare, to name just a few. Higher wages are likely good for workers and the local economy, but they crimp companies' profits.
In 2012, the risk of state ownership was brought into the limelight when the Russian government required its SOEs to pay 25% of their net earnings to shareholders in the form of cash dividends. Consequently, the country allocations of many emerging-markets dividend strategies shifted, in a big way, toward Russian stocks.
Wisdom Tree Emerging Markets High Dividend ETF (DEM), a strategy that weights stocks by annual cash dividends paid, saw its allocation to Russian stocks explode to nearly 20% by mid-2013 from 1.3% in December 2011. Energy stocks followed a similar trajectory because the Russian market has a substantial stake in the energy sector. The timing could not have been worse, as the move increased the fund's volatility when oil prices declined in 2014 and 2015.
The risk in this situation wasn't necessarily the precise outcome of a larger stake in the Russian market. But this demonstrates the power governments have in directing how a state-owned firm spends its profits. While Russia's dividend mandate made its SOEs more attractive from a dividend-yield perspective, it also tied up retained earnings that could have been used to increase a company's value by reinvesting in operations, paying down debt, or expanding through mergers and acquisitions.
A rotating cast of characters
Emerging-markets economies are fickler than their developed-markets counterparts in the United States, Western Europe, and Japan. That contributes to the volatility of their stock markets and can lead to the closure or even collapse of entire markets. Indeed, country membership turns over more frequently in the emerging-markets universe than in the developed-markets universe, leading to higher portfolio turnover.
We don't have to go that far back in time to find examples. Stocks listed in Venezuela and Argentina were removed from the MSCI Emerging Markets Index in 2006 and 2009, respectively, when those markets became more difficult to trade. Greek stocks were added in late 2013, after the country's debt crisis led to a downgrade from developed- to emerging-market status. Over the past few years, stocks from Qatar, the United Arab Emirates, and Saudi Arabia were also added to the mix.
Many of the countries that churn in and out of the emerging-markets universe are niche markets, so the impact on an index fund's composition will likely be small. However, it also means those stocks are less liquid and more expensive to trade.
Trading and taxes
Trading emerging-markets stocks in a cost-effective way can be challenging. These markets tend to be less liquid, there are currency issues to consider, there may be transaction taxes, and we have seen instances in which local tumult has forced some to close for extended periods.
Regarding the exchange-traded fund structure specifically, markets like mainland China, South Korea, and Brazil (among others) prohibit in-kind redemptions, a transaction that allows ETF managers to rid their funds of securities with unrealised capital gains without having to make taxable distributions to investors. This mechanism is the linchpin of ETFs' tax efficiency.
ETFs that target stocks in these specific markets must sell shares directly to the market and pass along any capital gains to shareholders, potentially saddling them with an unwanted tax bill. In 2018, VanEck Vectors China Growth Leaders ETF (GLCN), a fund that holds stocks from mainland China's Shanghai and Shenzhen exchanges, made one of the most egregious capital gains payouts in recent years. Its 2018 distribution amounted to 8% of the fund's closing net asset value on December 31, 2018.
Riskier, but not unreasonable
Collectively, these risks don't paint a rosy picture, but that doesn't mean investors should avoid emerging markets altogether. If anything, greater risks further underscore the importance of diversification when investing in emerging markets.
Broad-market index funds that spread their assets over a range of stocks and countries are a reasonable way to go. However, greater risk in these markets reduces our confidence that broad-market index funds can outperform their Morningstar Category average.
* State-owned enterprise allocation in the MSCI Emerging Markets Index was taken from WisdomTree's online attribution tool for WisdomTree Emerging Markets ex-State-Owned Enterprises (XSOE), available at https://www.wisdomtree.com/tools#index-attribution& Data as of March 2, 2022.