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Morningstar Guide to Emerging Markets

Shani Jayamanne  |  26 Jul 2022Text size  Decrease  Increase  |  
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Introduction

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

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

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. 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.

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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.

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. Emerging markets can display drastic differences in returns depending on the timeframe and period you are observing. A particularly important consideration with emerging markets is volatility. 

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. 

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.

Access the Active Barometer Report and full guide on Morningstar Investor, as well as our medallist emerging markets funds. 

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.

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 walk through in detail, a few of these risks in the full Guide to Emerging Markets on Morningstar Investor.

Political and economic risk

Currency risk

Sequencing risk

Combatting the risk

Find out how we decide how much of a high-risk asset should be in your portfolio, and how we combat sequencing risk in the full guide on Morningstar Investor.

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.

Conclusion

Ultimately, there are many ways to incorporate emerging markets into your portfolio. 

However, 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.

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