Risks of investing in emerging markets

Emerging markets often seem to provide new investment opportunities, and their higher economic growth rates provide higher expected returns—not to mention the benefits of diversification. However, potential investors should be aware of some risks before sowing their capital seeds on one of these rising stars.

Key points

  • Since the early 2000s, emerging markets have been one of the hottest investment areas, with new funds and investments constantly emerging.
  • There is no doubt that an investor who finds the right emerging market investment at the right time may reap substantial returns, but sometimes underestimate the risks involved.
  • For high-risk, high-return investments, you need to understand and evaluate each type of risk peculiar to emerging markets before entering.

currency risk

Foreign investments in stocks and bonds usually generate returns in local currency. Therefore, investors will have to convert this local currency back to their national currency. Americans who buy Brazilian stocks in Brazil will have to use Brazilian reals to buy and sell securities.

Therefore, currency fluctuations will affect the total return on investment. For example, if the local value of holdings increases by 5%, but actually depreciates by 10%, then investors will suffer a net loss of total returns when they are sold and converted back to U.S. dollars. (For background, please refer to our tutorial on foreign exchange currencies.)

Non-normal distribution

The returns in the North American market can be said to follow a normal distribution pattern. Therefore, financial models can be used to price derivatives and make more accurate economic forecasts for the future of stock prices.

On the other hand, emerging market securities cannot be valued using the same type of mean-variance analysis. In addition, since emerging markets are undergoing constant changes, it is almost impossible to use historical information to map appropriate correlations between events and returns.

Relaxed insider trading restrictions

Although most countries claim to have implemented strict laws on insider trading, it turns out that no country is as strict as the United States in prosecuting these acts. Insider trading and various forms of market manipulation will cause market inefficiency, and stock prices will deviate significantly from their intrinsic value. Such a system may be subject to extreme speculation, or it may be severely controlled by someone who holds privileged information.

Lack of liquidity

Liquidity in emerging markets is generally lower than in developed economies. This market imperfection leads to higher broker fees and higher price uncertainty. Investors who try to sell stocks in an illiquid market face a great risk that their orders will not be filled at the current price, and the transaction will only proceed at an unfavorable level.

In addition, brokers will charge higher commissions because they must work harder to find counterparties. The illiquid market hinders investors from realizing the benefits of fast trading.

Financing difficulties

An underdeveloped banking system will prevent companies from obtaining the financing needed to develop their business. The capital obtained is usually issued at a high required rate of return, thereby increasing the company’s weighted average cost of capital (WACC).

The main problem with having a high WACC is that fewer projects will generate high enough returns to generate a positive net present value. Therefore, the financial system of developed countries does not allow companies to undertake more types of profitable projects.

Poor corporate governance

A solid corporate governance structure within any organization is related to positive stock returns. Emerging markets sometimes have weak corporate governance systems, and management and even the government have a greater say in companies than shareholders.

In addition, when the state imposes restrictions on company acquisitions, management does not have the same level of incentives to maintain job safety. Although corporate governance in emerging markets has a long way to go before it is deemed fully effective by North American standards, many countries have made progress in this area to obtain cheaper international financing.

Increased chance of bankruptcy

An imperfect system of checks and balances and weak accounting and auditing procedures will increase the possibility of corporate bankruptcy. Of course, bankruptcy is common in every economy, but this risk is most common outside of developed countries. In emerging markets, companies can write accounts more freely to gain a more comprehensive understanding of profitability. Once the company is exposed, its value will suddenly drop.

Since emerging markets are considered riskier, they must issue bonds with higher interest rates. The increased debt burden further increases borrowing costs and increases the possibility of bankruptcy. Nonetheless, this asset class has left much of its unstable past behind. (Invest in emerging market debt There are rewards that can be provided. )

Political risk

Political risk refers to the government’s unfavorable behavior and uncertainty in decision-making. Developed countries tend to follow free market discipline with low government intervention, while emerging market companies usually privatize as needed.

Some other factors that contribute to political risk include the possibility of war, tax increases, loss of subsidies, changes in market policies, inability to control inflation, and laws related to resource extraction. Major political instability can also lead to civil wars and industrial shutdowns, as workers either refuse to work or are no longer able to do their jobs.

Bottom line

Investing in emerging markets can bring considerable returns to one’s investment portfolio. However, investors must be aware that all high returns must be judged within the risk and return framework. The challenge for investors is to find ways to profit from the growth of emerging markets while avoiding exposure to their volatility and other drawbacks.

The aforementioned risks are some of the most common risks that must be assessed before investing. Unfortunately, the premiums associated with these risks can usually only be estimated, not determined on a specific basis.

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