HAVING started off my
contributions to Veterinary Practice
this year with two articles on general
investment principles – “How can
you get the best return on your
money?” in two parts – I moved on
in my last piece to discuss the first of
several investment options away
from the usual pooled equity,
property and fixed interest funds,
covering “alternative assets”.
This month I am
moving on to look at
the merits and risks of
emerging markets.
Improvements in
the level of corporate
governance and the
lowering of barriers to
entry mean that
emerging markets have
now become more
mainstream as investors
embrace the potential
for significant growth
from these fledgling
markets.
What are emerging
markets?
The “emerging markets” nomenclature
was originally coined by then World
Bank economist Antoine van Agtmael
but there is no single accepted definition
for what constitutes an emerging
market. Subsequently, there is no official
list of qualifying markets.
A widely used definition refers to “a
country that is considered to be in a
transitional phase from developing to
developed status”.
Emerging market countries are
restructuring their economies along
market-oriented lines, with many
experiencing significant economic
growth.
They can offer a wealth of
opportunities in trade, technology
transfers and direct foreign investment.
As their economies develop, so too does
the financial infrastructure and, of
course, their stock markets.
Commonly quoted examples are
Brazil, Russia, India and China
(collectively known as the BRIC
economies). In addition, many countries
in Eastern Europe, Latin America and
the Middle East are also considered to
be emerging markets.
The rise of EMs
Investors have pushed the case for
investing in emerging markets over the
past few years. The case for investing is
backed, in many cases, by impressive
statistics, as emerging markets contain
80% of the world’s Gross Domestic
Product (GDP). Yet they are still heavily
under-represented in stock market terms
(source: JPMorgan Asset Management).
The economies of countries such as
China and India are growing at a much
faster rate than the developed nations of
the West; typically two or three times
the rate of economic growth seen in the
US and Europe (source: JPMorgan
Asset Management).
One of the engines driving this
growth has been demographics. While
the populations of the developed world
are ageing rapidly, those of the emerging nations tend
to have a much
younger profile. The
developed world has a
working population (in
the age range 15 to 64)
of about 830 million.
This is set to fall to
less than 750 million
by 2050. In contrast,
the working-age
population in
emerging markets is
about 3 billion and is
expected to be more
than 4 billion by 2050
(source: JPMorgan
Asset Management).
This provides emerging
economies with a flexible labour force and an expanding consumer market.
A criticism often aimed at the emerging market economies is the
failure to convert GDP growth into
stock market performance.
Since 2006, that trend has been
changed and the stock markets of the
emerging economies have begun to
match their economic growth rates.
Over the 10-year period to the end of
February 2010, the IMA Global
Emerging Market sector average has
returned 132.0% versus 26.8% from the
FTSE Allshare and 0.4% from the
MSCI World Index (source: Lipper
Hindsight. Bid to bid, net income
reinvested, GBP).
However, it has not been an easy
ride. Emerging markets tend to fluctuate
more dramatically than other stock
markets and demonstrate greater
volatility, even over the longer term.
Clearly, investment in emerging markets
will not be suitable for all and investors
should carefully consider whether these
characteristics match their own attitude
to risk.
What are the risks?
In addition to the usual market risks of
equity investing, investing in emerging
economies raises a number of other
non-market factors that investors need
to consider before making a decision to
invest.
Political risk
Political risk, also known as geopolitical
risk, is the risk that an investment’s returns could suffer as a result of
political changes or instability in a
specific country. Instability could stem
from changes in trade or industrial
policy and could also include events that
affect political stability, such as
terrorism, coups or civil war.
Some emerging market economies
don’t have the stable, political
infrastructure of their developed
counterparts and subsequently deter
potential investors as the lack of fiscal
and monetary discipline creates a wildly
volatile backdrop against which the risks
far outweigh the potential returns.
Lack of corporate governance
Corporate governance is the set of
processes and policies affecting the way
a corporation (or economy) is directed,
administered or controlled. In the
developed economies there are clear
regulations for the treatment of
shareholders, and investors are a key
consideration regarding the future
direction of a company.
In less developed markets, it is not
unusual for a small number of
individuals to be responsible for vital
decisions over the control and
distribution of assets for an entire
company. Without structured regulation,
it is possible for these assets to be
segmented and excluded from
distribution to shareholders.
The majority of companies in a
developed market are managed and run
for the benefit of shareholders with
profits paid back in the form of
dividends. Without a clear level of
corporate governance, profits can be
distributed at the discretion of those in control and used to further their
personal wealth or support an unstable
political regime.
Currency risk
As with any investment into an overseas
market, the volatility of the local
currency against the investor’s home
currency poses a real risk to the level of
return. In developing countries, where
the currency may be more volatile than
more stable currencies, this risk can be
increased particularly over the short-
term.
Summary
Clearly, for those with the requisite risk
appetite, investing in the emerging
markets may present an attractive
proposition. However, the importance
of a sensible risk-based approach and
clear understanding of the factors
involved is key to accepting the
potential volatility, particularly in the
short-term.
Looking ahead to future articles, I
will be covering Financial Derivatives
and Exchange Traded Funds (ETFs)
before moving on to an explanation of
different investment styles.
- For further information or to
discuss any aspect of financial
planning, contact the author, a
founder member of The Ellis
McComb Partnership, 3 Mortimer
Street, Birkenhead, Wirral, CH41
5EU; telephone 0151 650 6520, e-mail
ellis.mccomb@sjpp.co.uk, website
www.ellismccomb.co.uk. The
partnership is an appointed
representative of St James’s Place
Wealth Management plc.
