Developed versus emerging markets: opportunity and risk

Index providers sort the world's stock markets into groups, and two of the best known are developed and emerging. The distinction matters because the two groups differ in growth prospects, risks and costs, and it affects how investors think about building a global portfolio. This article explains how markets are classified, what differs between them, why faster growth does not guarantee higher returns, and ways to approach emerging markets sensibly.

How markets are classified

Index providers, such as MSCI, FTSE Russell and S&P, classify countries using criteria that typically include:

• The size and maturity of the economy.
• The size, liquidity and depth of the stock market.
• How open the market is to foreign investors, including restrictions on capital flows and ownership.
• The quality of regulation, settlement and market infrastructure.

Developed markets include countries such as the United States, Japan, the United Kingdom, Germany and Canada. Emerging markets include countries such as China, India, Brazil and South Africa. The lists differ between providers, and countries move between categories over time. Below emerging markets there is a further group, often called frontier markets, which are smaller and less accessible.

What differs

• Economic growth. Emerging economies often grow faster, driven by population growth, rising incomes and industrialisation.
• Volatility. Share prices tend to swing more, and falls can be deeper.
• Currency risk. Emerging market currencies can move sharply, and in some cases have lost significant value over time, which affects returns for foreign investors.
• Governance and disclosure. Standards and enforcement vary more widely. Minority shareholder rights may be weaker, and some companies are controlled by families or by the state.
• Political and regulatory risk. Policy changes, sanctions, capital controls or sudden new rules can affect companies and investors.
• Liquidity. Some markets are thinner, which can make trading costlier and more difficult.
• Costs. Trading, custody and taxes can be higher.
• Valuations. Emerging market shares have often traded at lower valuations than developed markets, which reflects higher risk as well as other factors.

Faster growth does not guarantee higher returns

It seems logical that fast-growing economies should deliver strong stock market returns, but the link is weaker than people expect. Reasons include:

• Share prices already reflect expectations. If growth is well known, it may already be in the price.
• Growth may not reach shareholders. Profits can be shared with the state, or diluted when companies issue new shares, and returns on capital can be low if investment is poorly allocated.
• Index composition. The companies in an index may not represent the part of the economy that is growing fastest.
• Currency effects can erode returns for foreign investors.

Evidence over long periods has been mixed, with long stretches of both outperformance and underperformance relative to developed markets.

Differences within emerging markets

Emerging markets are not a single block. Countries differ in political systems, demographics, commodity dependence, reform progress and market structure. Some are exporters of raw materials, some of manufactured goods, and some rely on domestic consumption. Some indexes are heavily concentrated in a few large companies or sectors, such as technology or financials. Understanding what is inside a fund matters more than the label.

How investors approach them

• As part of a diversified portfolio. A common approach is to hold emerging markets as one part of a global allocation, often through a broad fund, instead of concentrating in a single country.
• Sizing the allocation. Many investors choose a modest share, in line with the weight of emerging markets in global indexes or according to their own risk tolerance. There is no single right figure.
• Broad funds versus single-country funds. A broad emerging markets fund spreads country risk. A single-country fund is a more concentrated bet.
• Active versus passive. Some argue that less efficient markets give active managers more opportunity, but cost and results vary, so check the evidence.
• Long horizon. Because of the volatility, emerging market investments suit money that you will not need for many years.

Things to check before investing

1. What the fund holds. Which countries, sectors and companies, and how concentrated it is.
2. Costs. The expense ratio and trading costs, which are often higher than for developed market funds.
3. Currency exposure. Which currencies you are exposed to.
4. Liquidity and structure. Whether the fund holds shares directly or uses derivatives, and how it handles market closures.
5. Your own tolerance. How you would react to a fall of 30% or more.

Common mistakes

• Assuming that economic growth means high stock returns.
• Treating all emerging markets as the same.
• Overlooking currency and governance risk.
• Concentrating in one country because of recent performance.
• Allocating more than you can tolerate losing in the short term.

A short checklist

• I understand why I want emerging market exposure.
• I know what my fund holds and what it costs.
• My allocation is a size I can live with.
• I have a long enough time horizon.

Emerging markets can add diversification and growth potential, but they bring extra risk. Treat them as one component of a broader plan, not a shortcut to high returns.