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Morningstar Guide to Emerging Markets

Shani Jayamanne  |  03 Jun 2022Text size  Decrease  Increase  |  
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Introduction

If you have paid any attention to markets recently, you would be aware of the record highs and bullish territory which markets including the ASX and S&P500 were operating in, up until the beginning of 2022. Investors had bid up prices to the point where the returns they were setting themselves up for, was not fair compensation for the risk undertaken. This was a market that we, at Morningstar, alongside many investors, believed was a bubble about to burst. High expectations will not continue to be met for investors in the same way we’ve seen with the bull run since 2008, with the current market characterised by tech selloffs, Wall Street losses, US markets flirting with bear territories and a repricing of risk underway. We’ve seen 45% of the shares that trade on the NASDAQ down more than 50%, over 20% are down more than 75% and 5% are down more than 90% in the period of January to May 2022. Although Australia has been slightly more insulated from these implosions, this volatility has unnerved many investors, leaving many questioning whether investing solely in these developed markets is the right choice. As advanced economy market bubbles begin to burst, emerging markets have piqued the interest of investors looking for alternate markets to delve in, with the hopes of generating a more favourable return or to diversify their portfolio.

What are emerging markets?

Emerging markets do not have an official, universally agreed definition, however, generally refer to markets of developing economies which have seen considerable economic growth and possess some, but not all characteristics of a developed economy.

These markets traditionally have greater yields than developed markets, as their economies are usually growing faster, with more potential for growth, albeit riskier. They do not have a single agreed classification and therefore, the countries categorised under the term emerging markets and their total number may vary dependant on the institution’s classification standards. A few common classification criteria include economic development, size and liquidity of its equity markets and accessibility for foreign investors, with the MSCI (Morgan Stanley Capital International) and IMF (International Monetary Fund) being the main institutions defining emerging markets. Some examples of emerging markets include South Korea, Taiwan, and Sri Lanka.

Exhibit 1

Source: MSCI Annual Global Market Classification 2021

It should be noted that not all emerging markets are the same. There is the top end of emerging markets, like Taiwan, South Korea and Israel that are classified as emerging markets by most and developed markets by some. Taiwan has also established bond markets, with a larger and more liquid equity market than some developed economies. Then on the other end of the spectrum is India – a country that has enormous opportunity to grow and succeed, which many emerging markets investors find extremely attractive. And then there is the in between. Groups of countries with varied economic, institutional, and social progress that can be a breeding group of significant opportunity, but also significant loss.

Some key characteristics of emerging market investing include uncorrelated returns, where these investments produce opposite results to developed markets such as the US. These investments are also very volatile and generally have cheaper valuation levels such as Price-to-Earning ratios than developed markets. Investing in emerging markets can also be less efficient than developed markets. This means that there is a bigger deviation between price and valuation – the implication being that human intervention, such as active management, may be more favourable for these investments.

The opportunity

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Undoubtedly, a lot of opportunity lies within these markets. Jeremy Grantham, a well-known investor, and cofounder of asset manager GMO, (which manages about $120 billion USD) is a good example of an experienced investor who sees emerging markets as more attractive than the US, Australia or the UK in the current market. Grantham retained a belief that there was a bubble about to pop, pointing to massive runs on Wall Street, which some may argue we are at the beginning of now in 2022. Aside from this, he sees major opportunities in emerging markets saying “Emerging markets in many ways are the growth that’s left in the system. They will guarantee to grow faster than the developed countries… they’re much cheaper, they haven’t been beat up, they don’t have as much speculative excess. They’re a respectable investment”. Ultimately, he thinks they will tumble with US equities, but will not have as far to fall, and the crash will not be as bad because they are cheaper.

We can have a look at Sri Lanka and Taiwan to see the potential of growth that these markets have. Sri Lankan stocks returned second to most in 2021 at 80%, behind Mongolia at 133% - an eye watering return. Similarly, the Taiwan Stock Market returned 22%, just behind the S&P500 by 4% and beating the ASX200 by 5% in 2021. Of course, these are under noticeably short time periods, but this provides a glimpse into why they have piqued the interest of investors who are hunting for returns outside of their own markets – as developed markets stop meeting expectations that investors have set for them. We see investors searching for yield, and asset allocations becoming more aggressive due to low yields and low interest rates. Although interest rates are now beginning to hike, the Australian economy has recently faced historically low rates at 0.1%, which has investors turning to markets, a phenomenon known as the substitution effect. We’ve seen this over the last few years as retail inflows have increased into stock markets around the world. When investors are facing bleak returns from other asset classes, they naturally substitute stocks for bonds and cash, particularly for investors with a focus on income generation. And that makes sense – there is a certain level of returns needed to achieve goals so when prospects are looking dire, investors look to riskier asset classes.

Exhibit 2

Source: Manulife Investment Management, Macrobond. Investment growth of $100,000 (Developed markets represented by the MSCI World Index and Emerging markets by the MSCI Emerging Markets Index)

Investors have been wary of emerging markets in the past as they are not as well researched or as saturated a market as US or Australian equities, but it is for this exact reason that they are potentially full of opportunity. Undiscovered or unknown investments have high growth potential and can be attractive (see graph above which shows the growth of $100,000 in emerging markets and developed markets). Investors have also been turned off emerging markets because it can be time consuming, especially if the due diligence is done yourself. There are quite a few hurdles which you may face such as different languages, account standards, access to information and customs that can complicate relative investment valuations.

The first signs of swelling interest in investing in emerging markets was during the early 2000s. Investors were seeing that markets like China, which at the time was experiencing incredible growth, were providing much more attractive returns as it was cementing its place as an economic powerhouse. The short-term returns were extremely attractive for investors, and from 2000 – 2009, the MSCI Emerging Markets Index, net of dividends, had an annualised return of 9.78%, compared to the S&P500 returning -0.95% annualised and MSCI World ex USA 1.62%.

However, emerging markets can also display drastic differences in returns depending on the timeframe and year you look at.

The darker side

It is evident that emerging markets draw a certain attraction with their potential for high growth, but there is also a darker side to these investments. If we look at the following decade from 2010 – 2019, the MSCI Emerging Markets Index returned 3.68%, World ex USA 5.32% and S&P500 13.56%. When we smooth out the returns like this, we ignore a particularly important consideration with emerging markets investing – volatility. Between 1988 and 2019, emerging markets outperformed US stocks by 34 percentage points or more per year four times (1993, 1999, 2007, and 2009) and underperformed US stocks by that same magnitude four times (1995, 1997, 1998, and 2013).

Exhibit 3

Source: Morningstar Investor

What we can take from this, is that emerging markets can provide extensive returns, such as the 80% in Sri Lanka in 2021, but there are other factors that need to be considered like debt defaults and currency, which do not make these returns sustainable. As previously mentioned, emerging market investments are less efficient than developed markets, which is reflected in the deviation between value and price. The bigger these deviations are, the more opportunity there is for you to pick and beat the index. When we look at the current state of valuations for emerging markets, we can get an indication from the price to earnings ratios (P/E) across ETFs. The MSCI World All Cap ETF has an overall price-earnings ratio of 17.10, the iShares S&P 500 sits at 19.93 and the MSCI emerging markets sits at 11.47 as of 26 May 2022. On a relative basis, emerging markets are appearing cheaper than all markets, and the US.

Investing in emerging markets

So how can you access this form of investment if you decide that they fit into your portfolio and can help you to achieve your goals? Although not impossible, it is relatively difficult and sometimes expensive to easily access direct equities in many of these countries. Collective investment vehicles such as funds and ETFs serve to provide a way for investors to access emerging markets with one trade, or one investment. As an investor, you should assess the characteristics of each asset class before deciding whether to access them passively or actively.

Active versus passive indexes

Passive indexes are, in many cases, cheaper than active. Management fees have a detrimental impact to performance, as well as many active funds underperforming their passive counterparts. These factors have led to investors turning to passive indexes. However, in a report that Morningstar publishes half-yearly, this may not be the best path to follow for emerging market investments. Active managers can add value to an investor’s portfolio depending on how inefficient the underlying market is. The degree of efficiency relates to how much the prices in the market reflect the underlying valuation. Nobody knows how efficient a market is, so the question comes down to how often an active manager outperforms their designated index. The idea here is that the higher the percentage of active managers that outperform a benchmark, the less efficient the market is, as there is opportunity for them to go out and find undervalued countries. This is normally a lot harder in markets where there is intense competition and widespread investor interest, such as the US large-cap or Australian large-cap markets – hence why they prevail in emerging markets.

The Active Passive Barometer report, while US focused, has some great insights. It showed that active managers have the most success against passive managers in these inefficient markets and had high success rates with international and emerging market funds.

Exhibit 4

Source: Morningstar Investor Active Passive Barometer Report

One core difference between active and passive funds in this space is that active managers are able to choose the countries they are investing in, and in what amounts. This something to be mindful of, as looking at the example of iShares MSCI Emerging Markets ETF and its region exposure as of 26 May 2022, reveals that 29.92% of this fund is in one country – China. The next largest holding is Taiwan with 15.45% and India at 13.02%. This means that approximately 58% of the index is tied up in three countries, with a particularly large holding in China and therefore, a fairly significant dependence on the success of one economy. We also see this in iShares MSCI World All Cap ETF which has 67.97% of its holdings in the US as of 26 May 2022. These countries tend to be much more volatile than developed markets, so this should be kept into consideration.

Risks of investing in emerging markets

As mentioned earlier, with greater chance of growth in emerging markets, there is also increased risk and volatility. Emerging markets have different considerations to what you would have investing in developed markets. We can walk through a few of these risks and examples, starting with debt defaults.

Political and economic risk

As emerging markets are generally in the growth stages of an economy, they are typically prone to more political and economic risk. The government structure may be less stable, and markets may often feel the consequences of volatile economic factors such as labour and resource scarcity, high inflation or deflation, and the lack of market regulation and monetary policies. All these factors can have a major impact on the economy, and in turn on investors in such markets. However, it’s pertinent to note that these risks are not level across all emerging markets – the level of risk varies from market to market. For example, the political risk in May of 2022 is extremely high in Sri Lanka, but is not at the same level in Taiwan.

If you are familiar with bonds or have listened to our episode on bonds on our podcast, Investing Compass, you may be familiar with the idea that US government bonds are considered risk free because they can essentially print money to pay back any outstanding debts that they have. With emerging markets – that simply does not happen, bringing debt default risk into play. Loans are usually issued in US dollars, which means countries like Argentina, most notably, are not able to just print money to pay back looming debts.

So, what happened with Argentina? Argentina has defaulted 5 times in the last 35 years – which is a pretty shocking track record. In June of 2017, before it’s triple hat trick, Argentina issued $2.75 billion US dollars of 100-year bonds, which we now know the fate of. Two years later, in 2019, Argentina announced they would default and struck a deal to restructure their debts on terms that roughly equalled 55% of the value of the original bonds. The outcome of this deal was that Argentina must comply to economic reforms, including extremely tight controls on government spending, corporate and individual taxation increases and an end to money printing. Choosing to invest in emerging markets makes debt default risk relevant to your portfolio.

Currency risk

We can also look at currency risk. Currency risk exists with any form of international investing – even with developed markets. This is simply the risk of possibly losing money based on currency movements. Although you would still face this risk when investing in the US or UK market, the degree of this risk is far higher when we are looking at emerging markets and add to the volatility. To manage this risk, investors have the option to invest in currency-hedged funds.

If we look at the MSCI Emerging Markets Index, which covers large and mid-caps across 24 emerging market countries, between April 2012 and April 2022, if you had hedged your currency risk, you would have received an annualised return of 4.28% if you were 100% hedged. In the same period, an unhedged investment would return 2.89%. We can compare that to the S&P500, hedged for the same period achieved 12.18% and unhedged 14.57% annualised returns. In this case, the unhedged performed better. In both cases, the performance of the indexes differed greatly, showing the impact of currency movements on an investor’s portfolio.

Exhibit 5

Source: Bloomberg and Mesirow Financial Currency Management

We can also look at an example of active funds such as Capital Group’s New World fund, which has a hedged and unhedged version. Since inception in 2017, Capital Group have achieved 53.88% with unhedged and 34.88% for their hedged which is a smaller discrepancy and impressive result, noting that it has declined in the past 6 months as of May 2022.

Exhibit 6

Source: Morningstar Investor

Exhibit 7

Source: Morningstar Investor

This is a great place to start diving into how to manage the risks of these investments and how they could be incorporated into your portfolio. We can take a closer look into volatility and see how it can impact your financial goals. Through this, you will hopefully be able to learn where emerging markets may play a part of your portfolio, or if it should at all. Volatility is part and parcel of equity and investing. As investors, we take on this risk for a chance at a higher return.

Sequencing risk

Looking at how sequencing risk works and taking it into consideration within your investment strategy can give us some insight into whether emerging markets has a place in your portfolio. Sequencing risk is defined as the risk that the order and timing of your investment returns are unfavourable, resulting in less money for your goals. This risk is especially dangerous for retirement goals towards the end of the accumulation phase and in early retirement when your savings pool is generally at its height and is more exposed to market movements given the volume of capital at risk.

Sequencing risk is most significant during the last 10 years of an investor’s accumulation phase and the first 10 years in retirement. The sequence of returns during this period has a significant impact on the sustainability of the retirement income, and this is where investors like yourself, will need to consider whether emerging markets fits into a portfolio for pre-retirees and retirees. A fall in market value of investments would also leave the investor much less time to recover and increase the probability of a shortfall of funds in the late stage of retirement.

We can go through an example to see how sequencing risk can impact returns. Let’s give an example of you having $1,000 to start and say that the market falls, and you lose 20%. Your investment is now valued at $800. A 20% gain on this now only restores your investment to $960, meaning that you would need 25% to bring you back to square. What this means is that you are now in a position where your money needs to work harder for you to even break even.

If we were to look at a more severe scenario where you have $1000 and lose 50%, like in the example with the emerging markets index, that will bring you to $500. A 50% gain only restores your value to $750 – you now need a 100% gain to get you back to square.

What both these examples show is that volatility and the sequencing of volatility can largely impact your outcomes. Emerging markets can perform very well, but later in retirement, when there is less time for your savings to recover, it should be considered that large drops and volatility may have dire consequences if incorrectly implemented within your portfolio. For investors close to retirement, large drops like this may mean that they will have to postpone their retirement date, re-join the workforce, or reduce expenditure and make different lifestyle choices to build up that wealth again.

Combatting the risk

So how do we decide how much of a high-risk asset should be in your portfolio, and how do we combat sequencing risk?

Diversification

Diversification is an obvious strategy that can be used to combat sequencing risk. The uneven returns that you often see with emerging markets can be combated by not investing all your money in emerging markets. The examples that we looked at earlier was assuming that the $1,000 investment made up your whole portfolio, and when scaled up to a size or value which may be more similar to your portfolio, presents itself as an even more daunting figure. However, by diversifying your investments and not investing all your money in emerging markets, allows you to combat these uneven returns and act to absorb the shock of any losses. Asset classes all perform differently over time, and this is exacerbated by the volatility that is intrinsic to emerging markets. You would have heard the proverb ‘don’t put all your eggs in one basket’ which is undoubtedly relevant when making investment decisions. Although it isn’t guaranteed that all your other investments will make positive returns, diversification acts to maximise returns by investing across different and dissimilar markets, industries, and financial instruments, that would hopefully react differently or opposingly to same events. This strategy can be used at all stages of your investing journey, and to varying degrees.

Your exposure to this aggressive allocation will also depend on a few factors, the main one being time horizon – if you are following a goals-based investing methodology. The closer you are to reaching your goal, the less volatility you want in your portfolio and conversely, the further away you are from your goal, the more risk you can afford to take on with more volatile assets like emerging market equities. This is because you have the benefit of time behind you. You can take on higher risk for higher reward, as you have time to make up any losses you may have experienced, without having to drastically change your planned retirement age, goal, or lifestyle to do so. If you are looking for more information on aligning your portfolio to your goals, you can review our Morningstar Guide to Portfolio Construction.

Bucket strategy

The bucket strategy is a type of structuring of assets in your portfolio and is a strategy that is more commonly found in retirement. The strategy is built around having buckets based on time horizon. For example, you can have a now bucket, a short-term bucket, and a long-term bucket.

  1. Now bucket Your now bucket can be used to keep a few years of cash for you to draw down, so that if markets fall dramatically, you have cash reserves to call on whilst waiting for the equity component, or in this case, emerging markets component of your portfolio to hopefully recover. Ensuring that you have a few years of cash investments means you are not worsening the situation by drawing down on a reduced base.
  2. Short-term bucket This is a 3-to-5-year bucket where you might hold bonds, term deposits, diversified and conservative investments with a 3-to-5-year time horizon. The aim of this bucket is to replenish the cash or the now bucket at set intervals.
  3. Long-term bucket The long-term bucket will be where you keep higher risk strategies that require longer time horizons of 5+ years. Emerging market investments can be a subset of this bucket. Although this strategy is generally used during retirement, this is not the only time that you can use the bucket strategy.

Conclusion

Ultimately, there are many ways to incorporate emerging markets into your portfolio. They have been heralded as one of the best opportunities that we are going to see for investing in today’s market, with many developed economies seen as overvalued. Up until the beginning of 2022 was a period of time where many respected investors and investment managers had agreed investors were teetering amongst a bursting bubble, and these markets can soften the blow in the short and long term. Although the COVID-19 pandemic has challenged emerging markets to rise to the occasion and navigate ever shifting economic landscapes, they have also made noteworthy progress on the macroeconomic policy front in recent years, perhaps instilling new confidence. However, new risks always seem to eventually rear its head, with the road ahead uncertain.

How you utilise emerging markets, if at all, in your investment strategy, is dependent on the amount of risk you need or are willing to take on in order to reach your goals, coupled with the time horizon you have. You can utilise emerging markets in the aggressive portions of your portfolio, and/or utilise a bucket strategy. It is important to be wary of the risks – sequencing risk, currency risk, volatility from political, economic, and social instability. In a diversified portfolio, these risks can be managed.

As mentioned, active managers have traditionally done well in this sector because of inefficiencies in the underlying market. Ultimately, it is under researched and for professionals. It is easier to find undervalued opportunities in these markets and beat their passive rivals.

Investing in emerging markets is not for everyone. It is crucial for you to do your research and carefully consider your goals and risk capacity before deciding whether to invest in these markets. At Morningstar, we always recommend fully understanding your investment, and this can help you keep a long-term mindset through volatility that emerging markets are known for. This guide has shown you both the opportunities and risks that lie within investing in emerging markets. With measured planning, these investments could be incorporated into your international equity allocation of your portfolio.

Resources in Morningstar Investor

Morningstar Portfolio Construction Guide

The Morningstar Portfolio Construction Guide offers suggestions on global asset allocation and the portfolio construction process.

Exhibit 8

Our Investment Filter

Our investment filter allows you to search through emerging market stocks, funds and ETFs. You’re able to find our equity and fund analyst reports for the investments that we cover.

Exhibit 9

Discover investments

Our Discover investments features provide a summary of investment ideas that have received ratings from our Equity and Manager research team. See our 5-star and Moat-rated equity ratings from the US, Europe and Asia and our Gold-, Silver- and Bronze-rated ETFs and Funds.

Exhibit 10

Morningstar Equity Research Reports

Morningstar’s Equity Research Reports contain a comprehensive view of each security that we cover. We provide an overall recommendation based on our calculated intrinsic value compared to the current price of the security. The key to our evaluation of each security is our assessment of the four key components of our fundamental analysis: the fair value estimate, uncertainty rating, economic moat, and stewardship rating. Our analyst report also includes our full investment thesis and comments on the valuation and risk of the security.

Exhibit 11

Morningstar Manager Research Reports

Morningstar’s Manager Research covers LICs, ETFs and Managed Funds. We provide our forward-looking qualitative Morningstar Analyst Rating along with detailed research reports. Our full analyst report includes our view of the role that the fund or ETF can play in a diversified portfolio as well as our assessment of the investment team, investment process and the various fees that investors are likely to incur.

Exhibit 12

 

Resources

Podcast: Investing Compass: Are emerging markets worth the risk?

Webinar: Morningstar Investing Bootcamp: Emerging Markets – Where is the opportunity?

Report: Active Passive Barometer report: A semi-annual report that measures the performance of U.S. active managers against their passive peers

Research: iShares MSCI Emerging Markets ETF (AU) (ASX: IEM) Analyst Report

Research: Capital Group New World Fund Analyst Report

Guide: Morningstar Guide to Portfolio Construction

Article: Waiting for the last dance (GMO), Jeremy Grantham

is an investment specialist, Individual Investor, Morningstar Australia.

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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