The hidden risks of investing in emerging markets

The plunge in Brazilian shares on Monday - 17% at one point - and the volatility experienced in the summer by investors in Korea and Taiwan, as investors began to question the AI story, have taken the shine off a great couple of years for emerging market investors.

They have also focused the mind on the difference between what is grabbing the headlines in the short term and what may be more important longer term.

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The negative market reaction to Brazil’s unexpected election result highlighted the importance of political risk for emerging market investors. It played to our fears about investing in developing countries, adding to traditional concerns about inflation, currency volatility, fiscal indiscipline and weak governance.

But these are not the most important risks in emerging markets. The bigger danger is a relatively new one: the significant concentration in Asian emerging markets and their dependence on a continuation of the AI boom.

Emerging markets have been kind to investors, and to me. The Lazard Emerging Markets Fund has been easily the best performing of the ‘10 for Ten’ portfolio I set out here in February last year - up around 60% in 18 months. But confidence is more fragile now than it was even a few months ago.

The key question when it comes to emerging markets is not whether they are riskier than developed ones but whether we are being adequately compensated for the risks we are taking and whether we really understand where those risks lie.

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Politics presents the most obvious of emerging market risks. And the re-election of President Luiz Inacio Lula da Silva at the expense of the market’s preferred candidate, Flavio Bolsonaro, showed the danger of going all in on one side of a binary bet. It is not hard to see why markets blanched. Brazil has a fiscal deficit of 9.5% of GDP and Lula was re-elected on a platform of debt forgiveness and increased welfare benefits.

The fall in the Brazilian real, down 8% against the dollar in its worst day since 1999, illustrates a second key emerging market risk: what you see in stock market terms is not necessarily what you receive. A rising market can count for nothing if it is wiped out by a weak currency.

Another Lula term highlights familiar emerging market risks - inflation and both fiscal and monetary policy. The market had hoped that a win for Bolsonaro would see a reduction in Brazil’s large budget deficit, a stabilisation of public debt, now amounting to 83% of GDP, and a reduction in the country’s double digit interest rates. These seem less likely now.

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The market reaction this week underlines one other risk for emerging market investors - liquidity. During market stress, foreign investors can rush for the exit at the same time. A relatively modest deterioration in fundamentals can deliver a disproportionately large fall in prices.

So, Brazil is a good example of the big and scary in emerging market investment. But it is less obviously important for most investors who are unlikely to have a significant exposure to this market in their portfolio.

Brazil represents around 4% of the MSCI Emerging Markets index so anyone investing in emerging markets via a diversified tracker fund, or even an actively managed fund without a big Latin American overweight, will have noticed but not been blown away by the aftermath of the election.

The relatively small weighting of Brazil in the index highlights where the really important risk lies for emerging market investors - and that is the extraordinary country and sector concentration they may not even be fully aware of in their portfolio.

The MSCI Emerging Markets index sounds impressively diversified. It has 1,165 companies in 24 countries. But this is an illusion.

In fact, just over 50% of the value of the index is accounted for by two countries - South Korea and Taiwan. Just three companies, the chip makers TSMC, Samsung Electronics and SK Hynix, are 29% of the index by themselves. Information technology now represents 44% of the emerging market index.

I think there is still a strong case for investing in emerging markets within a diversified portfolio. But it does require us to invest with our eyes open to the underlying exposures and risks that we are taking on.

The first thing we need to understand is that geographic and economic diversification are not the same thing. Taiwan and Korea, as we have seen, are a big bet on AI and semiconductors. As such they provide little diversification from the US technology sector.

India is a play on domestic consumption growth. Brazil and South Africa are dominated by commodities and resources. Mexico and Vietnam (strictly speaking a frontier market) provide exposure to manufacturing and exports. India and some Latin American and African countries benefit from the expansion of financial services as households become wealthier.

These are the stories that make the case for building an emerging market exposure. But they may be a smaller part of our investments than we think. And tech may be much more. 

What else you have in your portfolio is critical when deciding how much to hold in emerging markets. Let’s say you allocate 10% of your equity portfolio to emerging markets. In a £100,000 portfolio that might lead to £5,000 being invested in Korea and Taiwan.

Maybe that is appropriate, but what if you already hold half your portfolio in a global tracker fund? More than a fifth of that fund, another £10,000, will be held in just six stocks - Nvidia, Apple, Microsoft, Amazon, Alphabet and Meta. It is not hard to see the duplication of economic exposure.

There is still a good case for emerging markets. Developed markets have their own concentration problem. They are not immune to political and fiscal shocks. And emerging markets come with a valuation cushion, trading at less than 10 times earnings.

The greatest mistake with emerging markets is not taking too much risk. It is rather that we take risks we do not realise we have.

This article was originally published in The Telegraph.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Direct shareholdings should generally form part of a well-diversified portfolio of other investments. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.