Is Investing in Emerging Markets Worth the Risk?

A version of this article previously appeared in the January 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

The road to successful investing in emerging markets is littered with potholes, speed bumps, and tolls. The risks facing investors in these markets are many and acute. Over the 10 years through February 2022, the standard deviation of the MSCI Emerging Markets Index was 20% higher than the MSCI World Index (a proxy for global developed-markets stocks). But traditional measures of risk don't adequately capture the myriad risks present in developing markets, which range from poor governance to political strife. Nor do they scale the trading costs and taxes involved in gaining access to these markets.

Russia’s recent invasion of Ukraine, and the subsequent responses from governments around the world, are among the latest risks to have an impact on emerging-markets funds. As of this writing, governments have imposed a range of economic sanctions on Russia. But the effect on financial markets is far more complicated. The Moscow Exchange remains closed, while exchanges in Europe and the U.S. have halted trading in some locally listed depositary receipts of Russian companies. Investors that want (or must) sell these assets may not be able to--and in the event they can, those trades will come with hefty losses.

While not ideal, the impact on investors in broad emerging-markets funds should be limited, as Russian stocks and bonds represent a small fraction of the affected portfolios. But it serves as a reminder that emerging markets face incremental risks, as this historical montage demonstrates.

Corruption and Political Influence

One of the most recent and prominent examples of corruption in emerging markets came to light in late 2015. Executives at Brazil's state-owned oil company Petrobras PBR were caught in an intricate web of bribes and payments between the company's contractors, executives, and Brazilian politicians.[1] The scam drained money from the company while enriching the parties involved, including Brazil's former president Luiz Inacio Lula da Silva, who subsequently went to prison.

Harmful actions by crooked executives at emerging-markets firms are anything but novel. Russia was rife with these situations in the late 1990s as its economy attempted a transition to a capitalist democracy. In late 2000, investors discovered that Gazprom, Russia's state-owned natural gas behemoth, had sold off several major natural gas reserves to insiders, including its own executives and their families, at pennies on the dollar.[2]

Both of these firms have another distinguishing feature that increases risk. Petrobras and Gazprom are examples of state-owned enterprises: companies that are partially or largely owned by their respective governments. State ownership is far more prevalent in emerging markets than developed economies. You'd be hard-pressed to find state-owned firms in many developed countries, while estimates indicate that they account for a bit more than 20% of the MSCI Emerging Markets Index.[3]

State ownership increases risk because politicians' agendas don't always align with investors' interests. Corporations typically have a narrow objective of maximizing profits for shareholders, while governments' responsibilities include resource security, foreign policy, and social welfare, to name just a few. Higher wages are likely good for workers and the local economy, but they crimp companies' profits.

In 2012, the risk of state ownership was brought into the limelight when the Russian government required its SOEs to pay 25% of their net earnings to shareholders in the form of cash dividends.[4] Consequently, the country allocations of many emerging-markets dividend strategies shifted, in a big way, toward Russian stocks.

Wisdom Tree Emerging Markets High Dividend ETF DEM, a strategy that weights stocks by annual cash dividends paid, saw its allocation to Russian stocks explode to nearly 20% by mid-2013 from 1.3% in December 2011. Energy stocks followed a similar trajectory because the Russian market has a substantial stake in the energy sector. The timing could not have been worse, as the move increased the fund's volatility when oil prices declined in 2014 and 2015.

The risk in this situation wasn't necessarily the precise outcome of a larger stake in the Russian market. But this demonstrates the power governments have in directing how a state-owned firm spends its profits. While Russia's dividend mandate made its SOEs more attractive from a dividend-yield perspective, it also tied up retained earnings that could have been used to increase a company's value by reinvesting in operations, paying down debt, or expanding through mergers and acquisitions.

A Rotating Cast of Characters

Emerging-markets economies are more fickle than their developed-markets counterparts in the United States, Western Europe, and Japan. That contributes to the volatility of their stock markets and can lead to the closure or even collapse of entire markets. Indeed, country membership turns over more frequently in the emerging-markets universe than in the developed-markets universe, leading to higher portfolio turnover.

We don't have to go that far back in time to find examples. Stocks listed in Venezuela and Argentina were removed from the MSCI Emerging Markets Index in 2006 and 2009, respectively, when those markets became more difficult to trade. Greek stocks were added in late 2013, after the country's debt crisis led to a downgrade from developed- to emerging-market status. Over the past few years, stocks from Qatar, the United Arab Emirates, and Saudi Arabia were also added to the mix.

Many of the countries that churn in and out of the emerging-markets universe are niche markets, so the impact on an index fund's composition will likely be small. However, it also means those stocks are less liquid and more expensive to trade.

Trading and Taxes

Trading emerging-markets stocks in a cost-effective way can be challenging. These markets tend to be less liquid, there are currency issues to consider, there may be transaction taxes, and we have seen instances in which local tumult has forced some to close for extended periods.

With regard to the exchange-traded fund structure specifically, markets like mainland China, South Korea, and Brazil (among others) prohibit in-kind redemptions, a transaction that allows ETF managers to rid their funds of securities with unrealized capital gains without having to make taxable distributions to investors. This mechanism is the linchpin of ETFs' tax efficiency.

ETFs that target stocks in these specific markets must sell shares directly to the market and pass along any capital gains to shareholders, potentially saddling them with an unwanted tax bill. In 2018, VanEck Vectors China Growth Leaders ETF GLCN, a fund that holds stocks from mainland China's Shanghai and Shenzhen exchanges, made one of the most egregious capital gains payouts in recent years. Its 2018 distribution amounted to 8% of the fund's closing net asset value on Dec. 31, 2018.

Higher tax bills for emerging-markets investors also tie to the taxes they pay on dividends. Compared with developed markets, fewer emerging-markets stocks meet the Internal Revenue Service's qualified dividend income, or QDI, standards. That means their dividends are taxed at ordinary income rates rather than lower qualified rates established in the Jobs and Growth Tax Relief Reconciliation Act of 2003. Vanguard's 2020 year-end estimates, shown in Exhibit 2, indicate only half of the expected dividends distributed by Vanguard FTSE Emerging Markets ETF VWO would meet QDI standards--a considerably lower percentage than those distributed by its U.S. or foreign developed-markets ETF counterparts.

Riskier, but Not Unreasonable

Collectively, these risks don't paint a rosy picture, but that doesn't mean investors should avoid emerging markets altogether. If anything, greater risks further underscore the importance of diversification when investing in emerging markets.

Broad-market index funds that spread their assets over a range of stocks and countries are a reasonable way to go. However, greater risk in these markets reduces our confidence that broad-market index funds can outperform their Morningstar Category average. Consequently, our Process Pillar ratings for funds like VWO land at Average, and all three within our rated universe earn Morningstar Analyst Ratings of Bronze, thanks largely to their much lower fees relative to category peers, which give them a durable edge.

Another good choice is Silver-rated iShares MSCI Emerging Markets Minimum Volatility Factor ETF EEMV. This fund explicitly cuts back on volatility and tends to favor less-risky stocks. It won't completely avoid all of the perils in these markets, but it has taken some of the edge off and should continue to do so, setting it up for market-beating risk-adjusted returns over the long haul.

[1] BBC. 2018. "Brazil Corruption Scandals: All You Need to Know." https://www.bbc.com/news/world-latin-america-35810578

[2] Tavernise, S. 2000. "Directors Act On Asset Sales At Gazprom." The New York Times. https://www.nytimes.com/2000/10/28/business/international-business-directors-act-on-asset-sales-at-gazprom.html

[3] State-owned enterprise allocation in the MSCI Emerging Markets Index was taken from WisdomTree's online attribution tool for WisdomTree Emerging Markets ex-State-Owned Enterprises XSOE, available at https://www.wisdomtree.com/tools#index-attribution& Data as of March 2, 2022.

[4] Ellyatt, H. 2012. "Why Russia Is Set to Become a Big Dividend Play." CNBC. https://www.cnbc.com/2012/12/20/why-russia-is-set-to-become-a-big-dividend-play.html

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