Emerging markets

The term emerging market is associated with economies that are poorer than the developed world of the US, EU and Japan. Emerging economies are typically reliant on basic industries and agriculture rather than services and technologies. However, to be truly emerging a market needs to have an established and reasonably liquid stock exchange that is at least partially open to foreign investors, and a functional financial, legal and regulatory framework. If any of these characteristics are missing an economy may be considered only a “frontier” market by index providers such as MSCI.

Emerging markets are characterised by relatively rapid economic growth, growing urban populations and industrialisation. They are typically more volatile, have more capital controls and have less liquid stock markets than developed countries. Emerging countries contain 80 per cent of the world’s population and 10 per cent of the investable world market, as measured by MSCI.

Emerging markets and pension funds
Advocates of investing in emerging markets expect high rates of economic growth to filter through into earnings growth for the local companies and therefore stock market returns. Investing in emerging markets can also be used to diversify away risk, as they have a low correlation with developed world markets.

The prospect of strong returns from emerging markets requires a tolerance for equity risk, foreign currency risk and liquidity risk. Emerging market equities are likely to underperform bond returns in some periods – investment should always be made with a long time horizon.

A defined contribution (DC) pension scheme may offer an emerging market fund as one option for members. The long-term characteristics of the asset class are more suitable for those far from retirement; the risks must be clearly communicated to members.

Getting involved
Pension schemes can invest in emerging markets through a global equities fund or a dedicated fund. A dedicated fund could invest in all emerging markets or focus on a geographical region such as Latin America, or by other criteria such as economic strength in a Brazil, Russia, India and China (BRIC) equities fund.

The advantage of a fund is that investing in the developing world can be complicated, with unfamiliar languages, currencies and legal systems. Pooled funds are simpler and practical for smaller funds. Segregated accounts offer greater flexibility and may be cheaper for large funds.