Emerging markets: opportunities, risks and how to invest

The list of reasons people in invest in emerging markets includes their faster growing economies underpinned by large working-age populations, rising middle classes and increasing productivity.

This means countries like India, Indonesia and Vietnam may grow faster than developed nations for decade to come. Economic growth and stock market returns do not move in lockstep but over time stronger earnings tend to be reflected in higher investment returns.

However, returns can be more volatile because of greater risks like political instability and currency volatility, so investors need to consider the downsides alongside the opportunities.

Emerging markets are sensitive to the value of the US dollar because they often borrow in dollars rather than their own currencies. In addition, some emerging economies are significant importers of commodities like oil and copper and exporters of agricultural products which are priced in dollars.

These factors mean dollar strength is generally bad for emerging markets while dollar weakness provides a positive boost.

How have emerging markets performed?

The MSCI Emerging Markets index is a widely followed equity benchmark designed to measure the performance of large and mid-cap stocks across 24 developing countries.

The MSCI Emerging Markets index has delivered a 10-year annualised return of 11.9% compared with an 8.7% total return for the FTSE 100 index.

This means an investment of £1,000 made a decade ago into the MSCI Emerging Markets index would be worth £3,078 today compared with £2,300 from investing in the FTSE 100 (not incorporating charges).

Spreading risk and adding variety

Because emerging markets are often on different economic and interest rate trajectories than Western countries, linked to local consumption and internal infrastructure spending, they can sometimes thrive when developed markets are struggling, providing a cushion for portfolios.

The extra risks involved in emerging markets means investors often apply a discount which means they can trade on lower PEs (price to earnings ratios) despite their higher growth potential.

Finally, emerging markets provide access to specialist sectors and industries which are not well represented on the UK stock market.

For example, Taiwan and South Korea have some of the most important global technology companies like TSMC (Taiwan Semiconductor Manufacturing Company) and Samsung Electronics. Though as we come on to later, South Korea is not considered an emerging market in some quarters.

How can I get exposure to emerging markets?

Experienced investors may feel confident in researching and buying individual companies but may be prevented from doing so by restrictions on trading by overseas investors in certain markets.

While some platforms allow direct investments in larger markets, investors should beware of lower liquidity, wider dealing spreads and currency risks, including with instruments like GDRs (Global Depositary Receipts) and ADRs (American Depositary Receipts) which allow foreign companies to list shares on the UK and US stock market.

A quick and simple way to get access is to consider ETFs which track benchmark indices provided by MSCI and FTSE Russell.

These provide broad exposure with low fees and are easy to hold in tax-efficient wrappers like ISAs and SIPPs.

The largest and cheapest ETF is the iShares MSCI IMI UCITS ETF which has £33 billion of assets and annual charges of 0.18% a year. It seeks to track the MSCI Emerging Markets Investable Market index by buying all index constituents.

Largest holdings include TSMC, Samsung and Chinese entertainment and technology group Tencent.

What’s in the index?

The MSCI Emerging Markets index has become more concentrated in recent years driven by the boom in AI which has resulted in Taiwan and South Korea becoming the two most dominant markets in the index, and information technology having a weighting of 43%.

Unlike MSCI, fellow index provider FTSE Russell does not class South Korea as an emerging market, meaning China is the second largest market in its FTSE Emerging Markets index and the allocation to technology is lower at 35.5%.

This is why it’s important to take a close look at the index your chosen product is tracking to make sure you’re investing in the areas you want to.

Actively managed funds aim to provide a better return than the index but have higher fees than ETFs. The Lazard Emerging Markets fund is on AJ Bell’s Favourite funds list, which is a list carefully curated by a team of in-house experts.

The £1.6 billion fund benefits from lead manager James Donald’s vast experience who joined Lazard in 1996 and is supported by a deep team of analysts. The fund has outperformed its benchmark over three, five and 10-years.

Why invest in emerging market bonds?

While emerging equity markets are typically bought for growth, bonds are bought for extra yield, with average yields providing a premium to UK 10-year yields.

The higher yield reflects higher risks including sovereign default, currency volatility and political instability.

The specialist skills and extra risks associated with investing in this area means it is easier to use ETFs and active funds to gain exposure.

The biggest ETF is the JPMorgan USD Emerging Markets Bond ETF which has an average yield to maturity of 6.2% and annual charges of 0.4%.

Yield to maturity reflects the projected total yield where all bonds in the portfolio are held to maturity including capital gains and losses. The weighted average life of bonds in the portfolio is 11 years.

The M&G Emerging Markets Bond fund is on the AJ Bell Favourite funds list. The manager uses a flexible, unconstrained approach seeking to outperform a composite benchmark comprised of corporate and sovereign debt.

The £1.2 billion fund pays a dividend twice a year and has a 12-month yield of 7.4% and annual charge of 0.68%.

The fund may have significant exposure to emerging market currencies and therefore may display bouts of volatility.