When it comes to portfolio allocation, it’s important to consider global exposure. Investing in emerging markets creates diversification in companies across the U.S. and abroad. International exposure allows investors to access different growth opportunities, as well as types of companies and markets that they might not find domestically. Within the international space, investors should understand that many of the opportunities will fall into either developed or developing, also known as emerging markets. However, what is the difference and how can allocations toward each impact a portfolio?
Some distinguishing characteristics of developed nations include having more advanced economies, better-developed infrastructure, more mature capital markets, and higher standards of living. The higher standard of living is often evident in the large gap between per capita income levels in developed and developing economies.
Of course, with any kind of investment, there are a variety of risks and benefits that investors should weigh. Developed equity market valuations are well above long-term historical averages, making it more difficult to absorb unforeseen shocks. The backdrop of slow economic growth and less supportive demographics are a challenge for corporate earnings growth going forward. Developed economies have piled on a mountain of debt over the past decade, which may act as an anchor to economic growth and crowd out more productive spending in the future. With that in mind, the benefits of investing in already developed generally tend to include:
- More reliable accounting and financial reporting
- Avoidance of direct foreign currency risk
- Less risk of sudden political and economic instability
By contrast, developing countries tend to exhibit higher economic growth rates driven by younger populations, higher consumption levels, modernization of infrastructure, and integration with the global economy. In addition, there are risks to be mindful of given developing nations tend to experience higher levels of political and economic instability, which can create added risk for investors. Many investors have also learned the hard way that accounting standards and financial reporting requirements are much less stringent in emerging markets. This has translated into misleading — and sometimes fraudulent — financial reporting. Emerging market investors should also be aware of the additional layer of risk and volatility associated with foreign currency fluctuations. Declining currency values can negate returns or amplify losses.
The benefits, you ask? When investing in emerging market, one should expect higher returns given these amplified risks. However, that has not been the case over the past decade. The U.S. stock market has dramatically outpaced emerging market indices. While the benefits of higher GDP levels, stronger demographics, and a growing middle class are real and observable, those attributes don’t automatically translate into superior corporate earnings growth or equity market outperformance.
As with any investment, investors should turn to a trusted financial professional who can provide more information on investing internationally, and what opportunities in the short- and long-term might be the most promising given portfolio objectives.