Emerging market stocks

An emerging market is defined as an economy that is progressing towards standards of market liquidity, transparency, accounting regularity, and securities regulation which are standard features of what are termed "developed markets." The term 'emerging market' dates from 1981 when Antoine W. Van Antmael, an official of the International Finance Corporation of the World Bank, first coined the term. Emerging market economies encompass nearly 80% of the world's population and make up 20% of its economies.

The map figures to the right show the nations that are considered to be emerging markets.

In 1992, Farida Khambata, an official at the International Finance Corporation, coined the term "frontier markets" for nations with smaller market capitalization and less liquidity than nations classified as emerging markets.

Over time, national markets can migrate from the continuum of classifications, moving between developed, emerging, and frontier markets. Argentina provides an example of such migration. At the dawn of the twentieth century, Argentina was the seventh largest developed economy in the world. After the World Wars and Peron, Argentina dropped into the emerging market category. In 2009 Argentina was dropped into the frontier market classification by MSCI, Russell, and S&P.

As of October 2012, emerging market stocks comprised 13.60% of the global equity market.

Emerging market stocks


Many emerging market countries have stock markets dating back to the nineteenth century. However, reliable return data is not easily available for many markets. Current index providers have measured returns since 1989. Jorion and Goetzmann have examined global stock returns during the twentieth century and have published the results in their 1999 paper Global Stock Markets in the Twentieth Century. The results of the study are graphically presented in the figure to the right.

The data reflected in the table provides real returns, and due to the fact that dividend histories in many markets are not always available, the returns do not reflect dividends. Given that dividends in most markets averaged 4% during the twentieth century, adding 4% to the returns is a reasonable assumption for arriving at total real return.

Jorian and Goetzmann also point out that the historical returns record contains selection bias, since countries contained in the indexes are the ones that have been relatively successful.

Risk, volatility, correlation
A Vanguard white paper, International equity investing: Investing in emerging markets, examines emerging market stock returns over the 1985 to 2005 period. The paper examines returns, risks, volatility, and asset correlations.

The paper notes that emerging stock markets, in addition to market and currency risks, are especially susceptible to the following risks:


 * Political risks. Political instability can result from external conflict, coups, and racial and national tensions.
 * Economic risks. Economic policies and reforms can fail.
 * Regulatory and operational environment. The quality of market regulation, corporate governance, transparency, and accounting standards is often below that of developed markets.
 * Limits on investment. Foreign investment may be limited or taxed.
 * High industry/firm concentration. In emerging markets, a large share of a country’s stock market capitalization may be concentrated in a particular industry or company.

Over the 1985 - 2005 period, emerging market stocks provided the following returns and standard deviations, a measure of volatility. Note that emerging market stocks were more volatile than both U.S. stocks and developed market stocks. Over the same period, emerging market stocks displayed an increasing correlation (rising to nearly 80%) with both U.S. and developed stock markets. Correlations between emerging market countries also increased over this time period, but remained low (rising from 5% to 35%). These low correlations between national emerging markets suggest that the high risk and high volatility of single nation emerging market stock returns can prudently be mitigated by diversifying emerging market investments over a wide selection of countries. For example, the MSCI emerging market index annual returns have ranged from a low of -53.33% in 2008 to +78.51% in 2009. This compares to the Thailand market, which provided a 113.8% return in 1993 and was followed by a combined loss of 86.7% over 1996 and 1997.

Emerging market indexes
Dow Jones, FTSE, Morningstar, MSCI, Russell, and S&P now provide emerging market indexes. Country representation varies among providers, as evidenced in the following table. The variation in index composition results a dispersion of index returns.

Emerging market index funds
Vanguard introduced indexing emerging market stocks to retail investors on May 5, 1994. Currently, emerging market index funds are available tracking FTSE, MSCI, and S&P indices. . Russell has filed with the SEC for introducing an ETF based on the Russell Emerging Market Index. Emerging market style index funds are available in the small cap style class. Indexing emerging market stocks is a prudent strategy, given that indexing has consistently outperformed the majority of active funds, as the figure to the right illustrates.

Suggested asset allocation
Investors wanting to include emerging markets in a portfolio might consider the following.


 * Investors desiring to hold a market allocation of stocks might consider holding a global stock market index fund, which would hold market weights of domestic market, developed market and emerging market stocks.
 * Investors desiring to hold specific weights of domestic and international stocks, and wanting to hold a market weighting of developed market and emerging market stocks in the international allocation might consider holding a total international index fund.
 * Vanguard suggests that investors should allocate between 10% to 15% of the international allocation to emerging market stocks.
 * Rick Ferri, in his book All About Asset Allocation, suggests that investors employing multiple asset class portfolios should hold equal weights of international indexes: a european stock index fund, a pacific stock index fund, an emerging markets stock index fund, and a small cap international index fund.