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Emerging Market Risks

A few days ago, I received what I thought was a great question from a reader:

“Why are emerging market funds said to be risky? It seems to me that with countries like China or India, it’s a low risk bet that their economies will grow. It hardly seems like there’s any more uncertainty over there than there is right here at home in the U.S.”

Growth is Already Priced-In

As we discussed on Monday, every company’s stock price already includes the market’s estimate for that company’s future growth in earnings. And, therefore, the same thing is true for any particular group of stocks (such as the stocks that make up an index representing the Chinese stock market)–expected growth is already priced in.

So the risk is not that the companies in the index will not grow. The risk is that they will grow more slowly than expected.

Emerging Market Risks

And when attempting to guess the growth rate for a company in an emerging market, there are a handful of factors that cause significant uncertainty.

Accounting risk: In the U.S. and other developed markets, accounting standards are very well defined. Each transaction is recorded in a prescribed way (or one of a few ways), and financial statements are presented according to a very specific set of rules.

In contrast, in many emerging markets, accounting standards are not as thorough–the result being additional uncertainty as to the quality of information contained in a company’s financial statements. Naturally, this makes it even more difficult than usual to predict a company’s rate of growth.

Political risk: In emerging market economies, the governments themselves can often be less stable. If a country’s government is overthrown or one dictator is replaced with another, it’s nearly impossible to predict the fate of any particular company in that country. For example:

  • Will that company’s industry be popular with the new government, thereby receiving government support such as subsidies?
  • Or will that industry be unpopular, thereby incurring new taxes and fees?
  • Or will the new government nationalize the industry, thereby forcing out private owners completely?

Lack of regulation: Our regulatory system is imperfect, no doubt about it. But we have it good compared to countries in which bribes and corruption are an everyday part of the regulatory environment. Just like the accounting risk mentioned above, lack of regulation makes it more difficult to place trust in a company’s financial statements, thereby making it more difficult to accurately predict growth.

Currency risk: As with any international investment, there’s the risk that, even if it performs well, your dollar-denominated returns will be reduced as a result of that country’s currency decreasing in value relative to the U.S. dollar.

Historical Volatility

To the extent that risk can be represented as the volatility of returns, emerging markets stocks have definitely shown higher risk than U.S. stocks. (For example, Morningstar’s “risk” page shows significantly higher volatility of returns for Vanguard’s Emerging Markets Index Fund than for their Total Stock Market Index Fund.)

Should You Invest in Emerging Markets?

Despite the above warnings as to the high-risk nature of emerging markets, I don’t think it’s a bad idea to allocate a portion of your portfolio to them. Approximately 10% of my own portfolio is in emerging markets (via Vanguard’s Total International Stock Index Fund).

I just think that it’s important to know what you’re getting yourself into. :)

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Comments

  1. Great post…I had been curious as to the major differences between emerging markets and intl small cap equity etfs. I agree with not investing TOO heavily in this as well, and I think its important to remember that as long as its part of a balanced portfolio, it could be a great option.

  2. I prefer developed markets for international exposure. Indexing works well in efficient markets; however, as you point out, emerging markets may lack adequate regulation and are likely much less efficient. Don’t confuse that with an endorsement for active management in emerging markets, far from it. Those that are successfully exploiting inefficiencies in emerging markets are the bribing/corrupt insiders and governments themselves. I just can’t see how I’m adequately compensated for that risk, and more importantly, I don’t even see where I need to even take on such risk. Adding X% exposure to EM won’t mean I can save less or plan to retire any sooner with more confidence.

  3. Good stuff. I think this simply explains why “bet on China” is not a credible investment strategy on it’s own. The same thought process also explains the risk involved in a lot of other investment decisions. Just because I think smart phones will grow in popularity, that doesn’t mean Apple/Verizon/RIM/ATT stock are guaranteed to grow dramatically.

  4. “Approximately 10% of my own portfolio is in emerging markets (via Vanguard’s Total International Stock Index Fund).”

    If that’s the case, since Emerging is is about 27% of VGTSX, it sounds like you have about 40% of your total portolio in that one fund. OK, the fund has 47% in Europe and 26% in the Pacific (which I guess is mainly Japan and Austalia). But given the various risks you outline above, why would you have so heavy an allocation in international?

    (PS: And isn’t the fund supposed to include Canada sometime soon?)

  5. That’s correct. 40% of my portfolio is in Vanguard’s Total International Stock Index Fund. And yes, the index that the fund tracks has recently been changed to the MSCI All Country World ex USA Investable Market Index, which includes Canada.

    My reasons for a high international allocation can be found here. In short: I’m nowhere near retirement, I’m comfortable with volatility, and I don’t mind if my portfolio doesn’t closely track the US stock market’s performance.

  6. Together with mentioned risks you probably have forgotten for so called country specific risk. That concerns for example currently Australia because of repeated floods. The government will have to invest a huge amount of money to repair all destroyed parts and that will surely affect the state budget of the country and following on the stock prices.
    Larry is right about VGTSX, it doesn’t include Canada so far. Hopefully it will change soon.

  7. Julie/Larry: My understanding is that the index changed on 12/15/2010 to the MSCI All Country World ex USA Investable Market Index, which includes Canada. (You can see on this page that the fund is now tracking the new index.)

    The portfolio make-up provided on Vanguard’s site at the moment is as of 11/30/2010. They typically update it around mid-month, however, so the change should be reflected on the site within the next week.

  8. “And yes, the index that the fund tracks has recently been changed to the MSCI All Country World ex USA Investable Market Index, which includes Canada.”

    Re Canada, I don’t know how important that is per se, but when I check VG’s own site they do not indicate Canada as part of the holdings.

  9. Our posts must’ve crossed.

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