- Risk Tolerance: Emerging markets are not for the faint of heart. Returns will vary significantly from year to year, and substantial losses in the short term are not uncommon. From 1998 to 2004, for example, the MSCI Emeging Markets Index returns ranged from a high of 66% in 1999 to a low of -30% in 2000. So before investing in emerging markets, you need to candidly assess your risk tolerance. Fortunately, with a properly diversified portfolio, you can add riskier investments in the right amounts and increase your overall return while actually decreasing (or at least not increasing) the overall riskiness of the portfolio.
- Holding Period: Risk cannot meaningfully be evaluated without also considering the holding period. The history of the stock market tells us that the risk of equity investments, as measured by volatility, goes down the longer the investment is held. In other words, a stock investment is more likely to go down in value over a one year period than it is over a ten or 20 year period. The bottom line–if you will need to liquidate your investments soon, think twice about investing in emerging markets.
- Currency Risk: As with any investment in assets held in foreign currency, understand that the relative value of your currency to the foreign currency will impact your returns. An example best explains currency risk. If we assume that $1 can buy 1 Euro, than a European stock trading for 10 Euros will cost me $10. If in a year, the price of the stock has not budged, but it now costs $2 to buy 1 Euro, my investment has doubled as measured in U.S. dollars. That is, I can sell the stock for 10 Euros, and then sell the 10 Euros for $20. Of course, if over the course of the year I can buy 1 Euro for just $0.50, my investment would be cut in half, as measured in U.S. dollars. I know, clear as mud. The point is, foreign investments entail risks that domestic investments do not. If you are like many who believe the long term prospects of the dollar are not great and that it will go down in value as compared to many foreign currencies, than foreign investments become all the more attractive.
- Your View of the Future: Many believe that the best growth opportunities are outside the U.S. In recent years we certainly have seen substantial growth in countries such as India and China. Will it continue and at what rate? I tend to believe that we will see significant growth outside the U.S., although the growth rate will be very inconsistent due to a variety of reasons including political instability, terrorism and natural disasters. I’ll let you know in about 30 years if I was right.
So Now What?
If you do want to add emerging markets to your portfolio, the question is how much and which funds. I personally keep about 10% of my portfolio in emerging markets through Vanguard’s Emerging Markets Stock Index Fund (VEIEX). It has a low expense ratio of just .42% and has done reasonably well for me. I’ve owned the fund for a number of years, and if I were buying more emerging markets today, I’m not sure I’d pick this one. It has done well over the last few years, but just about all emerging market funds have performed well. This is one area where I believe an actively managed fund just may have an advantage over an index fund.
I’ve recently been reading Richard Ferri’s book, All About Asset Allocation. For young investors with many years left to retirement, he recommends 5% emerging markets and specifically lists DFA Emerging Markets (DFEMX) fund. The problem with DFA funds is that they must be purchased through fee-only advisors, and for this reason, I’ve stayed away from them. It’s unfortunate, too, because DFA offers some very unique indexing options. Anyway, I mention it hear to give you another perspective. If you’d like to research some potential funds, you can use Morningstar’s mutual fund screener to quickly identify potential funds.
As always, what’s right for you will depend on many factors that only you can assess. As we continue this series, we will look in more depth at actually constructing a diversified portfolio of investments.