Emerging Markets: Opportunities Abound, but Beware the Index

If investors want to invest heavily in Chinese tech stocks, we recommend they purchase funds after careful research. That way they can be sure of what they are buying. If they want to invest in the larger EM sector, however, they should seek funds that offer broader diversification of risk as well as return opportunities.

The case for investing in emerging market stocks is compelling. With the exceptions of Qatar, Greece and Pakistan, every country in the MSCI EM Index realized positive gains last quarter. The International Monetary Fund projects that emerging markets will grow twice as fast, if not more (with possible 5% increases in real annual GDP), than the advanced economies of the U.S., U.K. and Europe (with expected GDP growth around 2%).

EM equity gains are also being driven by stabilized commodity prices. This benefits users and producer nations, providing a more stable economic backdrop for EM countries and companies that operate there. Since the Taper Tantrum of 2013, EM countries have repaired their balance sheets. As a result, they are enjoying rosier economic prospects and improving fundamentals.

Political reforms in countries like Brazil and Argentina are bolstering confidence in their markets, while current account deficits have fallen significantly. EM countries also should benefit from increasing productivity enhancements as more capital investments take hold.

Equity valuations also favor emerging markets, which have recently traded at a price-to-earnings discount of more than 20% to advanced economies. On a forward basis, that discount is intact.

We believe EM equities have room to run, and they should be part of an investor's overall growth allocation. Yet investors who want to tap the potential of emerging markets must first understand what they own, to ensure they can receive the true benefits EM investing offers.

By owning the common passive EM equity strategies, investors could be exposed to far more risk than they realize. Concentration in a handful of high-flying Chinese tech stocks could bring exceptional returns — unless they stumble and drag the whole index down with them. Investors in these passive funds may have far less access to the growth potential of smaller emerging markets, and they might not receive the diversification benefits they were expecting.

The challenge for investment managers is helping our clients participate in the growth potential of emerging markets, while avoiding the many pitfalls blindly investing in developing markets can bring. It is not always easy — and it takes experience, commitment and focus — but well-chosen EM investments can often help informed investors meet their long-term investment goals, with fewer bumps on the way.