Sunday, November 29, 2009

Investing in Emerging Markets

In my Facebook note version of my previous article, someone asked for my take on investing in emerging markets. Here it is.

The short answer is that emerging markets make up a useful asset class to include in a well diversified portfolio, but I wouldn't recommend speculating on whether they're going up or down in the short term. I'd recommend holding emerging markets in something approximating their market weight; I'll expand on what that means if you read more.

To an investor, emerging markets means shares of stock in companies in countries who's economies and capital markets are emerging from less developed to more fully developed. Examples are Brazil, Russia, India and China (commonly referred to as BRIC). For most of us, it means owning shares of a mutual fund that owns emerging markets shares.

Emerging markets are a useful portfolio component because they often are not highly correlated with US stocks, or even with foreign developed markets stocks. This means that they often don't move up and down in sync with these other types of stocks, so even though emerging market stocks are quite volatile, when combined with other asset classes, they can actually reduce the volatility of the overall portfolio (smooth out the ride). However, in bad bear markets, such as the one we've just been through, the correlation of all risky assets often increases, thus failing to provide the diversification we want when we want it the most. However, in the long run, the diversification effect tends to work out well.

Emerging markets are a subset of foreign or international markets (from a US investor's perspective). So, your allocation to emerging markets is part of your allocation to international markets. So before considering emerging markets, you should determine your target allocation for international markets. A common recommendation is 20-30% of your stock allocation, but some respected advisors recommend allocations as high as 50%. The argument for the higher allocation is that the US currently makes up less than 50% of the global stock market value, so holding more than 50% in the US is overweighting one country just because you happen to live there (home country bias). There are several arguments for keeping international exposure lower, but I won't go into them here. Probably more important than the actual allocation is sticking to it through thick and thin, and rebalancing your portfolio if your international exposure deviates more than 5% from your target. I personally would recommend at least 30% international, but not more than 40% unless you study asset allocation theory quite a bit first.

The easiest way that I recommend to own a reasonable weighting of emerging markets is to own the Vanguard Total International Stock Index Fund (VGTSX), which was about 23% emerging markets as of 10/31/09. The weighting of emerging markets held by the fund will automatically be adjusted to reflect the current market weighting.

Market weight basically means the value of the stocks we're talking about (in this case emerging markets) relative to the total market value of all stocks. So, about 23% of the value of all the stocks the Vanguard Total International Stock Index Fund owns is in emerging markets. Of course, Total International is not the global stock market, but represents most of the non-US stock market value excluding Canada. Emerging markets makes up about 14% of the global stock market value.

If you have a low cost brokerage account, another easy (and inexpensive) way to get appropriate exposure to emerging markets is to buy an international ETF (exchange traded fund) that includes emerging markets. One I use is Vanguard FTSE All-World ex-US ETF, ticker symbol VEU.

You may have a 401K, 403B or similar retirement plan that only includes an international fund that doesn't include emerging markets (e.g., an international fund that tracks the MSCI EAFE index, which only includes developed markets -- this is very common). If your retirement plan doesn't provide access to emerging markets, you either must forego owning this asset class, or use assets outside of your retirement plan to own it. In this case, assuming you already have appropriate exposure to developed foreign markets, you can buy an index fund or ETF that invests only in emerging markets. Vanguard Emerging Markets Stock Index fund (VEIEX) or Vanguard Emerging Markets ETF (VWO) are what I use.

Some investors like to separate developed and emerging markets in their portfolios, and periodically rebalance them to predetermined targets; e.g., 75% of total foreign in developed markets, 25% in emerging markets. This would be another reason to use an emerging markets (only) fund or ETF, along with a developed markets fund or ETF (Vanguard has them all).

That's probably more than enough for now on this topic.

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