May 1, 2012

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Emerging Market Equities

Enduring Risks to Capture Emerging Growth

Scott Ulbrich

May 1, 2012

Emerging markets are broadly defined as countries or regions with above average economic growth prospects. According to the International Monetary Fund’s World Economic Outlook (April 2010), emerging and developing economies are expected to grow close to three times faster than advanced economies by the year 2015. As the United States faces a potential slower period of domestic economic growth, investors have an increased appetite for exposure to faster-growing emerging markets.

The Tradeoff: Risks vs. Returns
Emerging market equities have rewarded patient investors over time. As emerging markets mature, their citizens may enjoy a higher standard of living, spurring a new source of demand for food, clothing, technology, business services and other opportunities that more developed markets enjoy. Investors expect this new source of demand to translate into corporate earnings growth and higher equity returns for companies with exposure to these regions.

Over the last decade, investors have experienced stronger equity performance in emerging markets than developed markets. For the 10-year period ending March 31, 2012 the MSCI Emerging Market Index experienced an annualized gross return of 14 percent compared to a 4 percent total return for the S&P 500 Index. While the growth prospects of emerging markets are attractive, the valuation of emerging markets equities is an important factor to consider.

Diversification benefits of emerging markets may be less than expected. Emerging markets often have growth drivers that are independent from those of the global markets. However, due to the globalization of equity markets, correlations between emerging and developed markets have been increasing. That being said, there is still a diversification benefit of adding emerging market equities to a portfolio.

Investing in emerging markets comes with above average risk. While higher growth is projected in emerging countries, there are risks that investors may need to endure to participate in this growth. Emerging markets can have political and social instability, poor infrastructure, unstable financial markets, currency risks, limited economic diversification, weak corporate governance policies and a host of other issues when compared to more developed countries. It is these risks that investors expect to be compensated for through higher expected returns on equity investments.

Currency risk deserves special consideration when investing internationally, especially when dealing with emerging markets. Returns to foreign investors can vary significantly from the returns local investors receive due to the currency effects. Emerging markets have a tendency to exhibit less stable monetary policies and higher dependencies on a single industry for economic growth, resulting in higher volatility in their currencies.

Gaining Exposure to Emerging Markets

Investors have multiple ways to gain exposure to the growth prospects of emerging markets:

  • Mutual Funds. Actively managed mutual fund strategies allow portfolio managers to over- or underweight countries, sectors and securities in an attempt to outperform their respective benchmark. Passive investors can utilize lower cost index funds to gain exposure to broad emerging markets indices or more specific region/country exposure.
  • Exchange Traded Funds. Investors looking for passive exposure can do so through ETFs, which provide several investment options in the emerging markets space from broad diversified exposure to more region/country specific exposure.
  • Individual Stocks. Investors are limited in their ability to invest directly in emerging markets stocks due to foreign regulations, higher costs and lower liquidity. The additional risks associated with investing directly in emerging market stocks may outweigh any benefits of directly investing in these markets.

Before Investing
Emerging market equities have become a popular strategic asset class for investors as a result of strong performance and above average growth prospects relative to developed markets. Before making an investment, investors should understand the risks that are specific to investing in emerging market equities. These risks have resulted in higher market volatility, which investors must be able to withstand in order to capture the total performance of the asset class.

ETFs are subject to the same risks as their underlying securities, trade on an exchange throughout the day and redemptions may be limited and brokerage commissions are charged on each trade.

Please consider the investment objectives, risks and charges and expenses of a fund carefully before investing. This and other important information is found in the prospectus, which can be obtained from your financial advisor and should be read carefully before investing. 

Article provided by Robert W. Baird & Co. for Scott Ulbrich, Financial Advisor at the Salt Lake City office of Robert W. Baird & Co., member SIPC. He has more than 20 years of financial services industry experience, and can be reached at 801-869-3855 or 888-792-7640.

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