Equities by themselves aren't a homogeneous asset class. You can choose from domestic stocks as well as international stocks. In international stocks, you can invest in developed or emerging markets. Over the last decade, emerging market investing has gained a lot of traction. How can you invest in emerging markets and is it worthwhile?
First, it's important to understand emerging markets. They are developing countries that are generally growing at a faster pace than developed economies. They have lower per capita GDP than developed economies.
However, in many cases, on an absolute basis, their GDP can be higher than developed economies due to the higher population. For example, China is the world’s second-largest economy. India and Brazil are also among the top ten economies globally.
Investing in emerging markets
The lure of investing in emerging markets is quite simple. First, they are growing at a faster pace than developed economies. Since theoretically stock markets are a reflection of the economy, you would expect higher returns from emerging markets. Second, they provide diversification since emerging markets are a separate asset class in themselves.
Looking at the stock market performance over the last decade, U.S. stock markets have been among the best-performing markets. Despite all of its economic growth, Chinese stock markets have lagged and are even below their 2007 highs. Simply put, there hasn’t been any real correlation between economic growth and stock market returns as the textbooks might want us to believe.
Betting on emerging markets in 2021
Emerging markets look like a good bet in 2021. These economies have seen a lot of fund inflows and are injecting a lot of cash to lift their economies. Also, countries like India are doing economic reforms, which will help increase their attractiveness as investment destinations. Some of the emerging countries like China and India have handled the COVID-19 pandemic much better than the developed world.
Risk when investing in emerging markets
It's riskier to invest in emerging markets compared to developing economies. First, there's higher political risk and currency risk when you invest in emerging markets. Also, the policy environment can be uncertain in emerging economies. China’s risk profile has only increased under the current leadership, which has been more authoritarian than the previous leadership.
How to invest in emerging markets
There are several ways to invest in emerging markets, including:
- Directly buying emerging market stocks
- Investing in emerging market ETFs
- Investing in emerging market bonds
If you are looking to buy emerging market stocks directly, you can choose from ADRs (American depositary receipts) or invest in stocks that trade on foreign markets. However, not all brokers let you trade in foreign-listed stocks.
Unless you are a sophisticated investor with a good knowledge of emerging market stocks, you shouldn’t invest in emerging market stocks directly. However, don’t lose heart since there are plenty of emerging market ETFs that you can choose from.
Best emerging market ETFs
The following are the best emerging market ETFs that you can consider in 2021:
- the Vanguard FTSE Emerging Markets ETF (VOO)
- the Invesco Golden Dragon China ETF (PGJ)
- the Direxion Daily CSI China Internet Index Bull 2X Shares (CWEB
- the iShares MSCI India ETF (INDA)
VOO is a play on a basket of emerging market stocks. With an AUM of over $100 billion with high volumes and a low expense ratio, this ETF stands out if you are looking at diversified exposure to emerging markets.
If you are looking at country-specific exposure, PGJ gives you exposure to Chinese stocks. The ETF is overweight on Chinese tech companies. Currently, Chinese tech companies including Alibaba are trading at a massive discount to their U.S. peers and we could see the valuation gap narrow.
If you are comfortable taking a leveraged bet on Chinese tech stocks, you can consider CWEB, which has been among the best-performing emerging market ETFs over the last year. INDA is a good bet to invest in India, which is expected to be the fastest-growing major economy in 2021.