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Emerging Market Investments
Mexico: Profile of an Emerging Market
Risks and Rewards of Emerging Market Investments
How to Invest in Emerging Markets
The rapid development of the emerging stock markets, both in terms of size and activities, is one of the most exciting stories in today's financial markets. These relatively untapped markets promise potentially high long-term investment returns and opportunities to further diversify an investment portfolio.
Total foreign investment in emerging markets has increased to an estimated $300 billion, up from a few hundred million dollars in the early 1980s, according to the International Finance Co. (IFC). Most of this investment has gone to markets in Asia and Latin America, regions that have had rapid economic development over the past decade. In turn, this influx of investment capital has further fueled economic growth in these countries, some of which have featured investment returns topping 80% annually. *
Characteristics of Emerging Markets
Emerging markets are those of lesser-developed countries, which are beginning to experience rapid economic growth and liberalization. Examples of emerging market countries include Mexico, Malaysia and Thailand. The International Financial Corporation lists 22 countries that are considered emerging markets. Generally, these countries are described by a growing population experiencing a substantial increase in living standards and income, rapid economic growth, and a relatively stable currency.
Often, emerging market countries impose strict limits on foreign investment in an attempt to limit foreign ownership of domestic companies. Investors may be prohibited from owning more than a fraction of any one company, and they may also be restricted from repatriating profits from investing activities.
Mexico: Profile of an Emerging Market
The potential rewards -- and risks -- of emerging market investing can be readily seen from the experiences of investors in Mexico from the late 1980s to 1994.
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Emerging
Market Capitalization
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Market
Capitalization in $ Billions
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1987
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1996
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Argentina
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1.5
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44.7
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Brazil
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16.9
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217.0
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Chile
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5.3
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65.9
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Egypt
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2.2
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14.2
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India
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17.1
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122.6
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Korea
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32.9
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138.8
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Malaysia
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18.5
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307.2
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Mexico
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8.4
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106.5
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Philippines
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2.9
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80.6
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South Africa
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128.7
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241.6
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Taiwan
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48.6
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273.6
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Thailand
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5.5
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99.8
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Venezuela
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2.3
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10.1
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Source:
International Finance Corp.
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The boom in emerging market investment stalled suddenly in early 1994 when the Federal Reserve began its series of interest rate hikes. Foreign money started to flow back home, which sent many emerging markets plunging. The downfall accelerated with the Mexican devaluation of the peso. The Mexican stock market plunged more than 50% measured in dollar terms, which prompted some investors to sell securities indiscriminately in other Latin American and Asian markets. The result was a massive sell-off of stocks and bonds in almost all emerging markets.
Lessons from Mexico
Following a four-year surge, the decline experienced by many emerging market was considered inevitable by some economists. Many investors now realize that there is no "free lunch" on Wall Street -- the high returns of emerging market investing come with high risk. Uncertainty about the direction of economic policies, trade and currency deficits, and social unrest may have contributed to the decline in the Mexican market; these factors may also exist to various degrees in other emerging economies. These social and economic events can temporarily drag down the entire market, including companies with excellent prospects.
The Mexican debacle also reveals that emerging countries, especially those with a limited local investor base, are particularly vulnerable to the inflows and outflows of foreign money. The large inflows of foreign investment in the early 1990s sent many of the emerging markets soaring; but when foreign investors quickly pulled money back, the markets plummeted.
Currency risk can present another risk factor for emerging market investors. As the currency exchange rate fluctuates, so does the value of your investment in US dollar terms. Fortunately, many emerging countries have their local currencies pegged to the dollar, which can result in a relatively constant exchange rate.
Risks and Rewards of Emerging Market Investments
Emerging markets can be volatile; therefore, they are considered appropriate only for long-term investors with an investment time frame of 10 or more years.
With such high risk potential, why invest in emerging markets? To answer this question, one should first look at the economic fundamentals, which are the underlying support for any country's financial market. Many emerging market economies are growing at an annual rate of around 7% or more, about 2.5 times the growth rate of industrialized countries. According to the International Monetary Funds (IMF), emerging markets will grow twice as fast as the industrialized countries through this decade. Consider also that emerging markets currently represent 13% of global GNP and only 11% of the capitalization of the world's equity markets.
Along with high potential returns, emerging markets also offer diversification benefits. Because these markets tend not to move in tandem with those of developed countries, they may be rising while other markets are falling. Hence, they can help reduce the overall risk of a portfolio.
Based on these factors, many financial advisors recommend long-term investors allocate 5% to 10% of their stock portfolio to emerging markets.**
How to Invest in Emerging Markets
Be aware that emerging markets in general tend to be volatile, sometimes even when no serious problem presents itself in a specific market. Investors in emerging markets are therefore advised to potentially reduce risk through diversification among many different markets, and to maintain a long-term view.
Probably the only way an individual can efficiently invest in emerging markets is through a mutual fund. Emerging market funds concentrate on investments in these markets around the world or in a specific country or region. Some global and international funds may also hold a small percentage of their portfolio in emerging markets.
Also keep in mind that some funds which invest in stocks of emerging market companies may also invest in bonds issued in that country. In general, these funds may contain a greater mix of different types of securities than a domestic fund.
Mutual funds offer the advantage of diversification and professional management. Because emerging market investment management may require extensive, and expensive, on-site company research, annual fund management expenses associated for these investments may be higher than for other types of mutual funds.
Points To Remember
1. Emerging market investments can offer higher potential returns to long-term investors.
2. Allocating 5%-10% of your stock portfolio to emerging markets can help optimize diversification.
3. Emerging market investments entail higher political and liquidity risks than domestic investments, and as such may be more volatile.
4. Currency risks also affect emerging market investments. If the value of the dollar declines against the currency of the emerging market country, your return will be lower. The currencies of some emerging market countries are pegged to the dollar and usually do not fluctuate wildly.
5. Risk can be reduced by holding emerging market investments among different countries and regions of the world.
* Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Past performance does not guarantee future results
* These allocations are presented only as examples and are not intended as investment advice. Please consult a financial advisor if you have questions about these examples and how they relate to your own financial situation. The investor profile is hypothetical.
Copyright 1999 The McGraw-Hill Companies, Inc.
Standard & Poor's including its subsidiary corporations ("S&P") is a division of the McGraw-Hill Companies, Inc. Reproduction of Standard & Poor's articles in any form is prohibited except with the written permission of S&P. Because of the possibility of human or mechanical error by S&P's sources, S&P or others, S&P does not guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.
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