What's an Emerging Market, Anyway?

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. An earlier version of this article appeared Nov. 15, 2010. 

Question: I've noticed that Morningstar reports provide details on how much a fund has in developed versus emerging markets, which is helpful. But how does Morningstar define what's an emerging market and what's developed?

Answer: Thanks for a timely question. Owing to impressive growth statistics and strong-performing stock markets, investor assets have been flooding into emerging markets during the past year. But before you steer more of your money into developing markets, it's wise to take stock of what you have already.

You can see how a fund apportions its assets between developed and developing markets by clicking on the Portfolio tab for the fund; scroll down to the Market Classification section at the bottom of that page.  Dodge & Cox International Stock (DODFX), for example, stashed a healthy 19% of its assets into emerging markets, as of its most recently available portfolio.

Unfortunately for those trying to get their arms around what this actually means, there's no universally embraced definition of what constitutes an emerging, or developing, market. The fact that classification systems vary widely helps explain why investors will see conflicting information from one platform to another. For example, your fund company's website might not match what's on Morningstar.com. 

The terms "developing market" and "developed market" can also introduce a bit of confusion. Does a country's classification as developed or developing refer to its actual economy or to the extent to which it has a liquid, modern, "developed" securities market?

Morningstar takes the former approach, relying on the World Bank's methodology for classifying markets as developed or developing. To arrive at a country's classification, World Bank focuses on a country's economy and, in particular, its relative level of wealth per capita. Countries with high levels of per capita income are classified as developed. Meanwhile those countries with low, middle, and upper-middle incomes per capita, relative to incomes in other countries around the globe, are classed as developing, or emerging. To see the complete methodology document, as well as which countries qualify as emerging and developed, click here.

For the most part, the output of this classification system syncs up with what you would expect. The United States, Canada, Western Europe, Australia, New Zealand, and Japan all count as developed markets, as do rapidly growing and relatively wealthy countries such as South Korea. (South Korea is still classified as an emerging market under some frameworks, however, such as MSCI's.) And even though the classification is determined by level of affluence, it's worth noting that these countries' securities markets are generally quite developed, too.

But relying on a country's level of wealth to determine its market classification can also introduce some odd permutations. For example, countries such as Barbados and Qatar earn the "developed" label because of their relative level of affluence. But their securities markets aren't as advanced as some countries that land in the emerging bin, such as Brazil and Mexico.

That's curious, to be sure. But head-scratchers like Barbados and Qatar aren't widely held in most funds, so the vagaries of the system shouldn't have a big impact on what you see when you eyeball your holdings' developed versus developing exposure.

At the same time, bear in mind that you may have more emerging-markets exposure than a glance at your holdings' country of domicile would suggest. Before layering on additional emerging-markets stakes, be aware that you may have indirect sources of emerging-markets exposure, too, as my colleague Kevin McDevitt details in this article.

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