Should You Invest in Emerging Markets? Read this Primer First

Investing in developed markets like North America, Europe and Japan comes with certain expectations — securities regulations, accounting standards and reasonably stable governments, to name a few.

However, when it comes to emerging markets (EM), many of these norms don't always apply.

So, just how are emerging markets defined and what are some considerations for investors who may be looking to this segment for potential opportunities? Let's take a look.

Understanding What Defines Emerging vs. Developed

Emerging markets are global economies that are taking deliberate strides toward becoming developed, and typically share some of the characteristics of already-developed nations. In the broader emerging-market category, each country is at a different stage in its development as far as markets, governments and economies are concerned.

When compared to developed markets, emerging markets generally have:

• Lower per capita income
• More prevalent political uncertainty
• Higher economic growth rates
• A tendency for larger currency fluctuations
• Higher and more frequent market volatility
• Less-developed capital markets
• Less-established regulatory regimes

Which countries are considered emerging markets?

In 2001, a Goldman Sachs economist came up with the acronym BRIC to refer to the largest emerging markets economies of Brazil, Russia, India and China. Since then, South Africa and Indonesia have occasionally been added to this popular acronym, which is why you'll sometime see the acronym as BRIICS.

The MSCI Emerging Markets Index represents the performance of large- and mid-capitalization securities in 24 emerging markets. As of September 2018, there were more than 1,100 constituents in the index. The index classifies countries in one of three investment universes: frontier, emerging and developed. To be grouped in a given universe, a country must meet specific requirements for each of the following three criteria:

• Economic development
• Size and liquidity
• Market accessibility

Diversity Among (and Within) Emerging Markets

While emerging markets are often referred to as a homogeneous asset class, the diversity among emerging economies can be significant — and shouldn't be ignored. Even within a single emerging-market country, levels of development can vary dramatically between assets.

What Emerging Markets Exposure Can Look Like

Economic globalization means your investment portfolio may already have exposure to emerging markets — even if you don't see China, India or Brazil named anywhere in your portfolio. That's because multinational companies domiciled in developed countries may derive their revenue from emerging-market regions. A U.S. company that sells its product or service to China, India, Peru, Mexico and other countries is heavily dependent on the emerging markets, despite being listed on a North American exchange.

Challenges and Opportunities

Investing in emerging markets comes with a set of challenges and opportunities that differ in ways from investing in stock markets in Canada or the U.S.

Here are four considerations:

1. Economic growth. Economic growth, as measured by gross domestic product (GDP), is typically higher in emerging markets, as they play "catch up" with developed economies. In the last couple of decades, economic leadership traditionally held in the U.S., Europe, Japan and Canada, has been transitioning to the emerging economies in Asia, Latin America and Africa. According to estimates from the World Bank, more than 75 per cent of the global rise in GDP since 2008 has come from these "faster-growing" economies.

However, the link between economic growth and stock-price growth is tenuous and the fate of individual companies does not always rise and fall with economic trends.

2. Geopolitical risk. Emerging economies can be more susceptible to political upheaval and socioeconomic shifts as they experience the natural growing pains of a nation evolving. Examples include political shifts that could stun markets, military unrest, foreign policy changes, trade wars and environmental issues.

3. Demographics. Market watchers often keep a close eye on demographics. For investors, a growing middle class with disposable income may indicate growth in consumer spending, which can lead to increased company earnings. Demographic trends, if accompanied by a stable government, job growth and other positive economic indicators, can present potential opportunities.

4. Volatility. Stock-price volatility can be very high in emerging markets. The reasons for this are numerous, including dependence on exports, commodity prices, trade issues, political upheaval and more. It's not uncommon to see extreme price fluctuations in emerging-markets securities, which means it's important for investors to know how much risk they're comfortable taking on in their portfolios.

For investors considering adding emerging-markets investments to their portfolio, understanding the significance of all the factors at play can help you determine if its an area right for you.

The title of this article was updated on January 9, 2019.