Investing in emerging markets can sometimes feel like a leap of faith. Such countries often let individual companies decide how much—or how little—financial information to disclose to investors. And with that lack of transparency comes risk: The less insight you have, the harder it is to see the whole picture.
But times are changing. Many emerging-market economies are making great strides in improving their corporate governance and investor protections. Several, including Malaysia and South Africa, even boast corporate governance scores well above those of some developed economies, according to a 2016 report published by the International Monetary Fund (IMF).1
That’s not to say improved corporate governance is a panacea that will propel an emerging-market economy to developed-market status; however, such advances can help emerging-market companies attract more capital, strengthen their balance sheets and weather external shocks. “Ultimately, improvements in transparency and corporate governance can increase the valuation of emerging-market stocks that were previously discounted because investors deemed them too risky,” says Michelle Gibley, director of international research at the Schwab Center for Financial Research.
Obscure no longer
During the past three decades, emerging markets have gone from fringe asset class to portfolio mainstay, thanks largely to their higher growth prospects relative to more-advanced economies. In 2017, for instance, the gains racked up by the MSCI Emerging Markets Index outstripped those of the S&P 500® Index by 15 percentage points (37% versus 22%, respectively).
However, the downside can be just as dramatic: During 2008’s global financial crisis, the MSCI Emerging Markets Index returned –53% (compared with –37% for the S&P 500). Because investors had limited information with which to judge the potential impact of such a downturn, IMF researchers theorized they were more likely to flee to the relative safety of other, more-above-board investments.
As transparency and corporate governance improved, researchers were able to test their hypothesis under real-world conditions. In examining the global downturns of 2013 and 2016, they found that when an emerging economy moved from the lower to the upper end of certain governance indicators, the impact of a global shock to the country’s companies was reduced by an average of 50%.
No quick fix
Of course, not all emerging markets have improved equally in terms of transparency. And there are other risks to consider, including currency fluctuations, political instability and increased volatility.
“You can’t focus on just one criterion when deciding where to invest,” Michelle says. “Places like Turkey, for instance, might be improving in transparency but could also have a deteriorating political environment.”
Indeed, increased transparency might be most useful as a deciding factor when comparing potential emerging-market investments. Sources such as the IMF, the World Bank and the World Economic Forum can be helpful in understanding which countries are rated highest for investor transparency or are trending in the right direction, Michelle says. (See “Into the light,” below.)
Transparency International, a global watchdog group that has been critical of emerging markets’ progress, has its own scoring system for corporate reporting and anticorruption measures.
“Many emerging-market countries have great regulations in place concerning corporate transparency, but those regulations are not always implemented effectively,” says Katja Bechtel, head of the organization’s business-integrity unit. Katja points to her team’s report, Transparency in Corporate Reporting: Assessing Emerging Market Multinationals (2016), which evaluates the disclosure practices of 100 major emerging-market multinationals, as a barometer for how effectively companies are responding to local transparency laws.
Pulling back the curtain
If, after weighing all available information, an investment in an emerging market still seems like a good fit for your portfolio, ask yourself the following questions before making a move:
Where’s the listing? Investors interested in an emerging-market stock should first see whether it’s listed on a major U.S. exchange with an American depositary receipt (ADR) designation. Such companies are required to file an annual report with the U.S. Securities and Exchange Commission using generally accepted accounting principles, which allows investors to effectively compare companies in similar industries across geographies. If no ADR is available, check to see if you can gain exposure to the stock via an emerging-market mutual fund or exchange-traded fund (ETF).
Am I sufficiently diversified? Investing in emerging-market stocks through index mutual funds and ETFs can be a relatively low-cost way for investors to achieve diversification. Failing that, be wary of overconcentration by country or industry. For example, Schwab suggests conservative investors allocate about 5% of their portfolios to international equities (including both developed- and emerging-market companies), while moderate investors may want closer to 15% and aggressive investors as much as 25%.
Should I go active? In addition to passively run index mutual funds and ETFs, investors may want to consider actively managed mutual funds, whose dedicated country and regional analysts are often better able to monitor corporate and market developments than individual investors. They may even spot improvements in governance and transparency that can benefit a stock before others catch on. However, actively managed funds often carry higher fees and frequently underperform their passively managed counterparts, so do your due diligence and make sure you’re getting your money’s worth.
What You Can Do Next
- Need help with your international investments? Call 888-484-5340 to speak with a Schwab investment professional.