International Diversification with Emerging Markets ETFs
Emerging markets offer investors increased diversification and growth potential – albeit at greater risk. We take a closer look at the pros and cons of this investment opportunity.
Emerging market economies have historically offered some of the best growth opportunities for risk-tolerant investors seeking international diversification and a higher return. And this continues to be the case today. The growth potential of developing countries across the globe can be hard to ignore - with an array of seemingly attractive investment opportunities - but just what are the risks associated with investing in these emerging markets? Let’s find out more.
What are emerging markets?
Emerging market economies (also known as developing market economies) are typically defined as those transitioning towards more industrial and manufacturing activities – with the corresponding levels of infrastructure and regulation – so their economies become increasingly integrated with global markets.
Developed countries share certain characteristics such as:
- Stable and strong economic growth
- Relatively high GDP per capita
- Highly liquid capital markets (equity and debt markets)
- Attraction of foreign investments (stable politics and currency)
- Reliable regulatory and legal system
Conversely, emerging markets are characterized by having:
- High rates of economic growth, albeit with higher market volatility
- Relatively low GDP per capita
- Greater growth and investment potential
Emerging market economies of note include:
- India
- China
- Brazil
- South Africa
- Russia
Why invest in emerging markets?
Emerging markets can provide higher prospective investment returns as they generally have large populations with increasing purchasing power at a quicker rate than developed markets. This means there are more customers for businesses to serve and larger end-markets for businesses to operate within. Excess growth has been shown to deliver excess returns as many studies indicate that revenue growth has explained the majority of stock price performance.
Another point to consider is that emerging markets are an effective diversification tool for Canadian investors who wish to not be overly exposed to North American markets. If these markets were to experience a sustained downturn, or underperformance, for example, then it would be prudent for investors to diversify not only by sector, but also by geography as well.
Lastly, emerging markets provide valuable exposure to the shifting global economic trends such as (1) greater utilization of transition metals; (2) intensified focus on energy security, and; (3) continued favorable demographic and urbanization trends.
Emerging markets are well placed to benefit from these trends since their economies are often driven by commodity prices and possess higher exposure to natural resources.
Risks of investing in emerging markets
As with all things in investing, higher return potential also comes with higher risk. Canadian investors who seek to gain exposure to emerging markets must also be cognizant of the greater volatility and loss potential of these investments.
Some risks that emerging market economies have outsized exposure to include:
- Currency risk: the value of emerging market currencies is highly unpredictable and can be very volatile, which may erode an investment’s return if not hedged. Currency risk is linked to an unstable economy
- Economy risk: an underdeveloped economy may not efficiently be deploying labor and resources and is also more likely have high inflation or deflation and underdeveloped capital markets
- Political risk: emerging markets typically have government and legal systems which may not be stable and at times can be highly corrupt
Emerging markets exposure through ETFs
For Canadian investors, cognizant of the higher risk-return profile of emerging markets investments, ETFs offer an effective way to gain low-cost exposure. There is a huge range of available options covering everything from concentrated, single-market exposures to more diversified funds tracking broad emerging market indexes.
The NEO Screener is a great way to search and compare funds that meet your specific needs but one of the most liquid and low-cost emerging market ETFs includes:
Vanguard FTSE Emerging Markets All Cap Index ETF (VEE)
This ETF tracks the FTSE Emerging All Cap Index and invests in all market capitalization sizes, however is more heavily tilted towards large-cap companies, which make up 55% of its holdings. Its largest country exposures include China (29%), India (20%), Taiwan (15%) and Brazil (8%).
- AUM: $1.6B
- Expense Ratio: 0.24%
- YTD Performance: -11.1%
- Management Strategy: Passive
Data for this article is as of December 14, 2022.
Please note this article is for information purposes only and does not constitute investment advice.
