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.
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.