Emerging market stocks have performed poorly this
year, but it's not time to write off this asset class just
yet. Emerging market stocks still deserve an
allocation in all but the most conservative, riskadverse
How bad is it?
In 2004 through the end of August, the Vanguard
Emerging Markets Stock Index Fund gained just
0.6%. Compare these results with 2003 when the
fund surged 55%.
The Emerging Markets Stock Index Fund is
designed to match the performance of the Select
Emerging Markets Free Index of approximately 500
common stocks of companies located in emerging
countries around the world. The 500 Index Fund
mimics the S&P 500 Index, which is dominated by
the stocks of large U.S. companies. These funds
closely track their respective target indexes.
Emerging markets include the vast majority of the
world's economies, countries such as Mexico, China,
South Africa, and Singapore. Although many in
number, the combined economic power of emerging
markets pales in comparison to the world's top
economic powerhouses: the United States, Japan,
and several countries of Western Europe.
Strong Growth Projected
But this is changing. Emerging economies are
growing rapidly and are projected to outpace growth
in developed markets. For example, the average real
gross domestic product (GDP) of Brazil, Russia,
India, and China (the BRICs) is projected to increase
6.8% this year, then rise another 6% in 2005.
Compare this growth to the more sedate
projected average of developed economies: 3.6%
this year and just 2.6% in 2005. Real GDP, by the
way, excludes the effects of inflation. Last year
Goldman Sachs predicted that in 40 years, the total
output of the BRICs will be more than that of a
group of six of the largest developed economies.
An investor might expect to find the stock of
companies in these fast-growing economies rather
expensive. Not so.
To understand why, let's compare the P/E ratios of
emerging market stocks with those of more
developed markets. The P/E, or price/earnings
ratio, is a common measure used to gauge how
expensive a stock is. The higher this ratio, the more
expensive the stock. Sometimes there's a good
reason for a higher cost. Fast-growing companies,
for example, generally have higher P/Es than slow
In contrast, fast-growing emerging market stocks
have lower P/Es on average than relatively sluggish
large U.S. companies. At the end of June
the average emerging-market company P/E was
13.6, compared with 21.7 for the S&P 500.
Fast growth and comparatively low prices, then,
characterize today's emerging stock markets. Yet
many investors are hesitant to invest overseas.
Emerging market companies in particular have
historically proved far riskier than domestic stocks.
The economic, political, and legal development of
emerging markets is judged less mature. Because of
this, these investment markets are subjected to
higher levels of default, corruption, political unrest,
and property confiscation, just to name a few.
Overshadowing all of this is currency risk, the
possibility that the value of emerging currencies will
have dropped when converted into U.S. dollars.
A History of Problems
As this is being written, the Russian government is
apparently taking over one of the country's major oil
companies, Yukos, and investors have suffered
significant loss. Argentina is still recovering from a
2001 debt default and subsequent currency
devaluation that sent investors scurrying for the
exits. There was a Mexican crisis in 1994-95, an
Asian meltdown in 1997, and a Russian default in
1998. In each case, emerging markets plunged. In
short, investing in emerging markets remains risky.
Let's not be too smug, however. The 1990s tech
bubble and subsequent meltdown reminded us
about stock market risk here in our own country.
Today, we continue to have problems in the U.S.
with accounting irregularities, bankruptcies, investor
fraud, corruption, etc. Investing, whether at home or
abroad, is inherently risky business.
Risks Should Continue to Decrease
Over time, emerging market risks should continue to
decrease as these countries draw closer to the
economic, political, and legal standards found in
more developed economies. For example, the
International Monetary Fund predicts continuing
improvement in emerging country balance sheets.
The credit rating agencies are starting to take notice.
"Over the past five years there has been a steady
increase in the credit quality of emerging markets
issuers," reported bond management company
Pimco in April, "with nearly 50 percent of the
emerging market sovereign universe now rated
While the developed and developing economies of
the world grow more interdependent and often
prosper or suffer together, the pace of development
among individual countries varies considerably.
Moreover, emerging economies are increasingly
trading and cooperating with each other. As this
continues, emerging economies should become less
dependent on and perhaps less affected by the
fortunes of the developed economies. Thus
emerging markets as an asset class should continue
to diversify a portfolio and reduce overall risk.
Best Entry Point
Finally, not all emerging markets are created equal.
It's a big job to evaluate these numerous economies
and their companies. It's a job better left to a
professional whose main responsibility is to monitor
these temperamental markets. For most investors,
then, the best entry point is through a low-cost noload
mutual fund or exchange traded fund that
invests in worldwide emerging markets.
Make sure, however, that your emerging market
investment fits into an overall diversified portfolio
allocation, and that you don't overdo it. An
allocation of 5% or so of an overall portfolio is
about right for most investors.