Emerging market funds had a challenging year in 2013 and the first quarter of 2014 wasn’t much better. Some of the lull was attributed to a sell-off sparked by speculation that the Federal Reserve Board was going to start cutting back stimulus efforts. A slowing economy in China, a sharp drop in Russian stocks and the potential for a recession in these countries caused a drag on some funds. In all, broad developing world funds fell by 0.06 percent in the first quarter of 2014.
But analysts say developing markets should still play an important role in a diversified portfolio, and chances are you already have some direct or indirect exposure. Those with a long-term view should see this as a minor correction in a promising asset class.
Investors need to take a careful look at the countries they’re investing in, says Chris Phillips, a senior investment analyst at Vanguard Investment Strategy Group. A fund may be investing in companies in that country that don’t correspond to what the investor thinks they’re buying. Phillips points to Nigeria as one example. It’s typically noted for its oil industry, but the publicly traded stocks available are mainly in finance and banking.
In another example, Phillips says the biggest areas of economic growth in China are often hard for foreign investors to reach. China doesn’t allow foreign investment in things related to national security such as infrastructure or utilities so investors are limited to things like real estate companies and financial firms.
“You may not be getting access to what you think you are when you invest in some [emerging markets],” Phillips says. “You might have poor translation from the economic growth you’re targeting to the return you see.”
There are subcategories of countries within emerging markets. On the top of the scale are “developing” emerging markets that are near developed status (many argue whether Taiwan and South Korea should still be considered emerging markets). At the other end are frontier markets, which are even less developed than emerging markets themselves. They can come with moderate levels of risk including poor liquidity, sub-par regulation and financial reporting, political instability and even large currency fluctuations. But for all their risks, many of these frontier markets are some of the world’s fastest-growing economies and can offer spectacular performance.
“The biggest challenge with frontier markets is the transparency and liquidity,” Phillips says. “You might not get what you think you are getting, and there is a lot more risk [in some of these countries].”