Wednesday, 30 September 2015

Humans are creatures of habit. Even if we seek adventure, most of the time we come back to what we already know. From an investment perspective, emerging markets represent a step away from the known. And many investors around the world have either invested in emerging markets or are contemplating doing so. The question for us is whether it is in members’ best interest to move away from the more familiar and to venture into less well known markets.

Firstly what are emerging markets? There is actually no universal definition for these markets. China is generally classified as an emerging market for example but is also the second biggest economy in the world. But while precise definitions vary, there are common characteristics that are associated with emerging markets. Emerging countries are usually defined as economies that are at some early stage of the industrialisation process, with low to medium income per capita. They contain approximately 80 per cent of the world’s population and represent around 30 per cent of the global output. Social development indicators, like literacy rates or life expectancies are usually low and there is a tendency towards urbanisation. They can often have a political system that is less democratic than our own. Typically, but not always, they’re embarking on programs of structural and economic reforms intended to achieve a more solid and responsible economic performance and increase transparency and efficiency in financial markets.

Emerging markets were historically viewed as a source of natural resources, cheap workforce and low production costs, but were not widely considered an overly attractive investment allocation option. Over recent years, rising expectations of relatively stronger economic growth in these countries, and quite simply the size of these countries as a percentage of global GDP, has changed this view. These markets are now attracting a lot of attention from investors and they’ve become too big not to consider.

So is investing in emerging markets in our members’ best interests? Some of these economies are young, and like any youngster, it’s hard to know which direction they’ll choose and who will make them take that direction. It’s hard to anticipate how their companies and governments will react during an economic crisis. They often display institutional and governance weaknesses, corruption, social inequality, infrastructure limitations and high competition for natural resources. They can be more vulnerable to volatility and unpredictable devaluations and, on top of that, low levels of liquidity can make it difficult to invest.

Emerging markets typically display growth rates that are higher than mature and industrialised countries. Even in countries like China that are currently experiencing slowdowns, growth rates are still positive and higher than most developed countries. Interestingly, history has shown that high growth rates don’t directly equate to higher returns. If high growth is expected, it becomes factored into the price of an investment. It therefore tends to be changes in growth rates compared to expectations that impact returns – either for the better or  worse. As emerging markets are riskier than developed markets for all the reasons listed earlier, we would hope for a higher return from these markets. But risk means just that, we could experience a range of outcomes. So returns from emerging markets, as from developed markets, will largely be unknowable from year to year.

The biggest opportunity that emerging markets offer is diversification. Emerging markets comprise a range of economies at different stages of development and business and market cycles than developed economies. So there is potential to see better returns in these countries when returns are low or weak in developed countries.

So while we’re very aware of the risks attached to investing in emerging markets, we believe that there’s a case to be made for holding some level of investment exposure to these economies. At present we only have a very small exposure to emerging markets but expect that in ten years’ time this will be much larger. In the meantime we’re seeking to better understand the risks and opportunities to determine the most appropriate way and time to invest in these markets. Finding the right time to invest in these markets will always be a challenge. When things are going well they tend to look expensive and when things are going badly in these countries they feel very risky. It’s likely that we’ll gradually build our exposure over time and we’ll keep you updated on the progress of this.

 

The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of QSuper. This information is for general purposes only. It is not intended to constitute advice and persons should seek professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.

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