Additional Risk in Emerging Markets

There is little debate that understanding risk is an important aspect of successful investing. When it comes to analyzing risk, historic metrics such as standard deviation and drawdown are typically used as a proxy for the level of risk contained within a given asset. However, high-level metrics such as these gloss over the nature and composition of those risks.

When comparing foreign stocks to U.S. stocks using these measures of risk, it becomes apparent that there is some amount of incremental risk in both developed and emerging markets. Exhibit 1 compares the volatility and drawdowns of stocks from the United States, foreign developed markets, and emerging markets during the past 10 years through May 2017.

The higher volatility and deeper drawdowns attributed to non-U.S. stocks can come from several different sources. One major contributor is foreign exchange rates. Currency fluctuations can increase volatility but often provide little in the way of additional compensation. Local economic policies, such as the United Kingdom's decision to leave the European Union, can also cause the returns of foreign stocks to jump up and down more than those listed in the U.S. But there is even more risk in emerging-markets stocks beyond currency fluctuations and local economic policies. Here are two examples of these risks that tend to receive less attention.

State-Owned Enterprises State-owned enterprises, or SOEs, can take different forms, and there is no clear qualifying standard when it comes to defining these institutions. Levels of government ownership in publicly traded companies can range from minority positions up to near full ownership. The risk here is that government stakes in a public company can introduce conflicts of interest between the government and public shareholders.

These conflicts arise from the different agendas and goals that each entity is pursuing. Corporations typically have a narrow objective of maximizing profits for shareholders, while governments deal with multiple responsibilities including resource security, foreign policy, and social welfare. As an example, high wages for employees are likely good for workers and their local economy, but concurrently hurt a company's profits. Indeed, these companies present a bizarre blending of capitalism and socialism that may not always benefit public shareholders.

Publicly traded companies like these are prevalent in emerging markets. Examples include Gazprom (Russia), China Construction Bank, and Petrobras (Brazil). Investors that own shares of an emerging-markets fund likely hold these types of companies. Exhibit 2 outlines several emerging-markets ETFs and the number of SOEs in their top 10 holdings.

Additional SOEs appear as you go down the list of holdings for these funds. But these funds are all market-cap-weighted, and companies further down the list consequently account for smaller fractions of the funds' assets. Their performance tends to have a small impact. This lends an obvious but important insight about investing in emerging-markets stocks: Diversification takes on greater importance in markets where SOEs operate. A simple way to achieve this is through a broadly diversified emerging-markets fund such as

Market Collapse As the name implies, emerging markets are less developed than more-established regions such as the U.S., Europe, and Japan. Emerging markets typically feature little legal and regulatory oversight, have underdeveloped infrastructure, and are more prone to experience changes in government regimes. This less stable nature not only lends itself to volatile stock prices, but can make investment in these countries expensive, and even lead to collapse and closure of entire markets.

For investors using index funds to gain access to these markets, these risks can manifest themselves through index composition. In just the past several years, the long-standing MSCI Emerging Markets Index has seen several changes to its member countries:

• Venezuelan stocks were removed in 2006 owing to investability restrictions linked to foreign exchange rates and lack of liquidity.[1]
• Argentinean stocks were removed and downgraded to frontier-market status in 2009. The cause here was restrictions on inflows and outflows of capital to the Argentinean stock market.[2]
• Greek stocks were reclassified to emerging-markets status, as the country failed to achieve MSCI's market accessibility criteria for classification as a developed market.[3]

The outcome of these reclassifications meant that funds tracking this index had to sell shares of firms domiciled in these regions, typically at a loss. Fortunately, most of these changes represented a small fraction of the overall emerging-markets capitalization. As an example, stocks from Greece represented less than one tenth of a percentage point of the cap-weighted MSCI Europe Index when the country was removed from developed-market status in November 2013.[4]

Aside from country reclassification, exchanges can sometimes temporarily shut down, making it difficult or expensive to liquidate shares. A recent example occurred in early 2011, when revolution swept through Egypt, causing the Egyptian Exchange to close. While trading of stocks in Egypt was halted, VanEck Egypt ETF EGPT continued trading in the U.S. In this instance, the ETF resembled a closed-end fund. However, there was no active underlying market for the basket of stocks that the ETF held, and redemption of ETF shares through an Authorized Participant wasn't likely to happen. Exhibit 3 shows that the fund's price diverged from its NAV during a two-month span from late January to late March.

The potential for market collapse underscores the need for diversification, not just across stocks, but countries as well. In many cap-weighted emerging-markets funds, Chinese stocks account for a disproportionate share of the fund's assets (typically around 25%-30%). Going forward, the inclusion of China A-shares is likely to skew this number higher. To help mitigate country-specific risks, some fund companies, such as DFA, actively take measures to promote diversification by capping exposure to individual countries. This should help reduce losses associated with market collapse when it occurs.

In both of these examples, a broadly diversified emerging-markets fund is essential to mitigate the impact from additional risk. But stocks from emerging markets are still volatile. Investors who can't stomach the additional risk could simply choose to avoid stocks from emerging markets altogether, though this isn't a great solution. One of the major benefits of emerging-markets stocks is that they expand an investor's opportunity set and can increase the level of diversification within a portfolio of U.S. and foreign developed-markets stocks. Those who wish to retain this diversification benefit at a reduced level of risk can use a low-volatility strategy, such as

References and Notes

[1] MSCI Barra. 2006. "MSCI Barra to Remove the MSCI Venezuela Index From the MSCI Emerging Markets Index. https://www.msci.com/eqb/pressreleases/archive/20060425_2_pr.pdf.

[2] MSCI Barra. 2009. "MSCI Barra Announcement on the Status of the MSCI Argentina and Pakistan Indices." https://www.msci.com/documents/1296102/1332381/MSCI+Announcement+-+Feb+18+2009.pdf/fa1d2571-4d61-4541-93a0-9b1d47ed1f2d.

[3] MSCI. 2013. "MSCI Announces the Results of the 2013 Annual Market Classification Review." https://www.msci.com/eqb/pressreleases/archive/2013_Mkt_Class_PR.pdf.

[4] Source: Morningstar Direct.

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