By Investopedia.com 10.04.2012
Emerging market investments can be a great way to expand your portfolio into less-correlated assets. Think about it: Your job, your home and every item you own is tied to the country you live in, so it makes sense to have some investments that aren't. With that said, there are some common traps that await the unsuspecting investor. In this article, we'll look at the four most common.
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Emerging market returns look great on a long-term chart, but if you zoom in on any given month, you'll likely see peaks and valleys that resemble the Himalayas rather than a steady upward climb. That volatility means that you are not going to get rich quick, nor are you going to be able to jump in and out for an easy profit.
The volatility in emerging markets is a result of many factors, including the less-than-regular flow of information from these markets. When information bunches or events start cascading across a region, the market reaction can be extreme and difficult to predict ahead of time. To be successful at investing in emerging markets, an investor is usually better off investing based on a long-term thesis, rather than any short-term outlook.
2. Politics and Law Are the Same Everywhere
Emerging markets tend to come with stability issues. This means that the ruling political parties and the economic conditions can change suddenly - sometimes several times a year. With political instability comes legal uncertainty. One day you are the owner of a share in a promising emerging market company, and the next day you are the former owner of a share in a company that the state now owns. Worse yet, there is not always time to sell beforehand.
This is one of the reasons that the election (or overthrow) of a certain political party can result in investment capital pouring out of a country. If a party is on record as having a desire to nationalize assets, investors usually go by the old adage, "better safe than sorry." To act on this, however, an emerging market investor has to keep an eye on international news events.
3. Abroad Is Diversity Enough
If you are in emerging markets for diversification, then you need to make sure you are actually getting exposure to different economic areas. The world is split up in many different ways, but the economic blocks are usually listed as Asia, Europe, North America, South America and Africa. Deciding which countries belong to which block is difficult - sometimes Russia is grouped with Europe, sometimes with Asia.
Categorising difficulties aside, the countries within these blocks tend to correlate heavily with each other, so investing in five different Asian countries may get you no broader diversification than investing in five different states. If diversity is your main goal, then it is important to go beyond a single world region. Exchange-traded funds (ETFs) are a very powerful tool for an investor looking for diversity abroad. These funds take off some of the upside that can come with direct investments, but they also reduce the risks by spreading the investment across a region's top stocks.
4. Missing Domestic Exposure
Because the rules are different, the volatility greater and the macroeconomics unclear, it is a mistake to discount investing in domestic stocks with emerging market exposure simply because they are domestic. Many companies pull revenue from emerging markets while also retaining a considerable domestic stream.
There are many companies that get over 50% of their total revenue from overseas. For example, domestic sales may be a large source of revenue for companies like Coca-Cola and McDonald's, but a majority of the total revenue comes from international sources. Like Coca Cola and McDonald's, these companies tend to have very strong global brands that make them attractive investments in addition to the global exposure. In short, these internationally leveraged domestic stocks offer the stability of mature economies and the growth potential of emerging markets in a single helping - usually with a dividend, to boot.
The Bottom Line
Emerging markets can be as good as advertised, as long as you are prepared for the real risks. Knowing that volatility will be high, and thus hamper your ability to get in and out in shorter time frames, will prepare you for a longer investment and make you spend more time evaluating it. Knowing that politics is a risk and that regions correlate, will help you look beyond the returns and spur an interest in international news. Knowing that you have domestic options will keep your standards from slipping just because a foreign business offers overseas exposure. In short, knowing all this will bring you closer to being an informed emerging market investor, rather than someone taking a flyer on hot foreign stock.