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The Risks of Investing in Emerging Markets

Emerging markets offer amazing opportunities for investors who want to make money while making the world a better place. But emerging markets also have some risks that investors new to the category may not have considered.

Political and social risks of investing in emerging markets

In any country, investors have to be concerned about changes in the political climate or in the way that society is organized. Even changes that make most people better off may leave a few behind, and sometimes those left behind are investors.

Many emerging markets began their economic improvement because of a major political change. For example, the emerging markets in Eastern Europe were once Communist nations but are now parliamentary democracies with market economies. The economic climate is really exciting for the people who live in these countries, not to mention for the people who invest in them. However, such profound changes create risk, and many nations in Eastern Europe have had economic and social upheaval on the way to economic stability.

Politics being politics, things may turn against investors. A country could experience an event, such as a war, ethnic unrest, or a natural disaster, that destabilizes the economy and pushes commerce down the list of priorities. Investors, especially those outside the country, won't necessarily be a consideration for a government tackling what it sees as bigger issues.

Corruption

In many emerging markets, corruption is a fact of business. In some cases, it's rooted in cultural differences, where people receive tips for services that wouldn't be rewarded anywhere else. In other cases, corruption is rampant because ineffective institutions have forced people to figure out ways to work around them. And in still other cases, the problem is nothing more than basic human nature combined with lax law enforcement.

Corruption affects a business's ability to present fair financial statements. It adds costs that may not be predictable or manageable. It can throw in surprises and make contracts void in court. Although a bribe may seem to be the quickest way to get business done, corruption is costly in the long run. As a rule, the less corruption a country has, the better its economy. Academic research shows that the less corruption a country has, the less volatile its investment returns are.

Currency risk of emerging markets

In most emerging markets, you use a currency other than your own. That means that your investment returns are affected by changes in the value of both your currency and the emerging market currency.

When you invest in another country, you almost always have to buy that country's currency to buy the investment. Then when you sell the investment to use the proceeds elsewhere, you also sell the currency. The change in the currency's value while you own the investment may enhance — or diminish — the investment's value.

In general, if an economy grows and has a lot of economic activity, its currency should be in great demand and should become more valuable. But currencies sometimes become less valuable over time. This drop in value may be because of economic changes or because the currency becomes overvalued and corrected, or it may just be that the emerging market currency is fine but your home currency has become more valuable for other reasons.

You can reduce the risk with hedging techniques. Keep in mind, however, that doing so may eliminate some of the return and diversification benefits.

Liquidity risk

Buying and selling securities in emerging markets isn't always easy. Some markets are just very small! Jamaica, for example, has a total market capitalization of $6.4 billion. Compare that to one company, Apple Computers, at $391.9 billion! Getting a position in some of these markets may be difficult, and you may have a hard time selling your position when you're ready to get out. This is known as liquidity risk.

Here are some factors contributing to the liquidity risk:

  • Thin markets: Many emerging markets are thin, as the traders like to say, which means that few people are buying and selling securities on a regular basis.

  • Limits on how much you can take with you: Some countries have laws that limit the amount of currency people can take out of the country, which means you may be able to sell your investment, but you may be prohibited from taking the cash home. Countries have these laws to help manage their exchange rates and to ensure good account balances in local banks.

  • Restrictions on buying and selling: Some nations may restrict who can invest and who can sell. In these nations, when it's time to sell, you may not be allowed to, or you may not be allowed to sell your entire position at one time. You need to know the laws of the country in which you invest and react accordingly.

If you limit your emerging market commitment to the part of your portfolio that's intended for long-term goals, low liquidity will be less of an issue because you're less likely to have to sell your positions on short notice.

Information problems

With reliable information, you can assess the risks and the potential return of your investments. In emerging markets, getting good information can be difficult. A country may have loose accounting standards, little media oversight, and few objective investment analysts paying attention to how companies are doing.

Even when the information is available, you have to work harder to get it. And information is expensive. You must expend time and energy to find media that report on a nation in a language you understand, to become familiar with the differences in legal and accounting practices, and to make sure that the investment you make is for real.

In most cases, information problems result in merely unpleasant surprises, but in a few cases, emerging market investments have turned out to be outright scams. Investors fall into the trap because they don't have enough information, don't ask the right questions, or ignore the obvious. One easy first question to consider is why you're being offered this fabulous investment opportunity. Is it because you have special expertise? Are you associated with an investment company that has been active in the region? If the answers don't add up or if the opportunity seems too good to be true, steer clear.

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