Emerging Market Primer
The practical considerations of investing in developing economies

By Akbar Ali, portfolio manager and vice-president, Dimensional Fund Advisors

Emerging market countries are reshaping the global economy. Their local public equities constitute an asset class that offers high expected returns as well as unique risks that can be managed through country evaluation and weighting, diversification, and trading strategy. What are some of the key characteristics that define an emerging market? And what should investors look out for when assessing an investment opportunity in a developing market?

Let’s start with how an emerging market is defined. Some institutional investors classify countries on a continuum basis, with the largest and most advanced markets falling into the developed markets category and the smallest and most difficult markets in the emerging markets camp. For every attempt at an explicit definition, there are exceptions: Taiwan, for example, is large and liquid, but has a history of volatile returns and restrictions on foreign investors.

Distinguishing features
Emerging market countries do, however, have characteristics that distinguish them from their developed market counterparts. These characteristics include high expected returns and high volatility; political and economic risk; liquidity concerns; and restrictions on foreign investment. However, the degree to which the above characteristics persist varies significantly among individual emerging market countries. Before investing, investors should evaluate their level of comfort with these factors and decide what conditions need to exist in a country before entry. They should then review countries based on whether they meet these conditions.

There are several relevant factors in the emerging markets investment decision. For example, is it a free market economy and does the country have a tradition of rule of law? A key indicator is a history of property rights, particularly for minority shareholders. Many investors are also concerned with social issues such as human rights and labour law. It is interesting to note that the countries that rank high in areas like rule of law and property rights generally rank high on social issues as well.

Another factor to look out for is the fair treatment of foreign investors. Signs of this include legal protections, enforceability of contracts, and the absence of penalties applicable only to foreign investors. Countries imposing repatriation restrictions and taxes only on foreigners (and not also on local investors) should be approached with caution, or not at all.

Countries also need a developed trading mechanism. While many emerging markets now offer electronic settlement, others still have physical settlement, which may cause problems such as failed trades. Some markets do not have a mechanism to ensure delivery versus payment, increasing intra-day risk of broker failure. Still others have a history of scrip fraud, which translates into a real cost of trading.

Emerging market approaches
With emerging market investing, holding a greater number of securities within each eligible country reduces company-specific risk. In addition, investors benefit by diversifying across risk factors such as size and style in emerging markets. Also, emerging markets have a tendency toward extreme highs and lows in performance, with rapid changes in direction. Hence, setting target weights and sticking to them in a disciplined fashion is beneficial. Market capitalization weights, by definition, offer the benefit of adjusting along with market movements, thereby reducing portfolio turnover. However, they generally force large percentage holdings into the top one or two countries. A limit on the maximum weight in any one country, for example a 10-15% cap on each country, can increase diversification in emerging markets exposure by limiting single-country concentration.

At the same time, trading costs can be particularly high in emerging markets. Both market impact and agency costs are vital components of trading costs and must be evaluated closely. Market impact can be up to ten times more significant and bid/ask spreads on even non-institutional quantities of small-cap emerging market securities can exceed 2%. Agency costs such as taxes and fees can be managed through an equity strategy with lower turnover.