Definition and Overview
Emerging markets is a term used to describe the economies and financial markets of countries that are in the process of transitioning from lower levels of economic development and financial market sophistication toward the characteristics of more developed market economies, including higher per capita income, more mature financial institutions, greater market depth and liquidity, stronger regulatory frameworks, and more stable political and macroeconomic environments. The term was coined by Antoine van Agtmael of the International Finance Corporation in 1981 as a more optimistic and investment-friendly alternative to the then-prevailing terminology of third world or less developed countries, and it has since become the universal designation for this economically and geographically diverse group of investment destinations.
Emerging markets encompass an enormous diversity of countries, economies, political systems, and investment environments. At one end of the spectrum are large, rapidly industrialising economies with sophisticated financial markets, significant institutional investor bases, and increasingly complex corporate landscapes including China, India, Brazil, and South Korea. At the other end are smaller, less liquid markets with limited institutional depth, significant political risk, and nascent regulatory frameworks. What these markets share is their position in an ongoing developmental trajectory toward the characteristics of developed markets, though the pace and path of that transition varies enormously across countries and over time.
The investment significance of emerging markets has grown substantially over the past four decades as these economies have collectively expanded their share of global GDP, their corporations have grown into globally significant businesses, and their financial markets have deepened to the point where institutional investors can deploy meaningful capital. Emerging markets now represent a substantial proportion of global economic output, an even larger share of global population, and a growing share of global corporate earnings, making them an increasingly important component of any genuinely globally diversified investment portfolio.
Classification of Emerging Markets
The classification of specific countries as emerging markets rather than developed markets or frontier markets is maintained by several major index providers and financial institutions, each applying their own methodology and criteria. The most influential classifications are those maintained by MSCI, FTSE Russell, and S&P Dow Jones Indices, whose emerging market indices serve as benchmarks for the trillions of dollars of institutional investment allocated to this asset class.
MSCI, whose Emerging Markets Index is the most widely referenced benchmark for emerging market equity investment, classifies countries as developed, emerging, or frontier based on three broad criteria. Economic development considers per capita income relative to World Bank high-income country thresholds. Market accessibility criteria include openness to foreign ownership, ease of capital flows, efficiency of the operational framework, stability and breadth of institutional investment vehicles, and availability of investment instruments. Market size and liquidity criteria include the number of companies and securities meeting minimum size and liquidity thresholds for index inclusion.
Current major constituents of the MSCI Emerging Markets Index include China, Taiwan, India, South Korea, Brazil, South Africa, Saudi Arabia, Mexico, Thailand, Indonesia, Malaysia, and numerous other countries across Asia, Latin America, Eastern Europe, the Middle East, and Africa. The composition of the index changes over time as countries are added, removed, or reclassified based on changes in their economic development and market accessibility characteristics. South Korea and Taiwan have been subjects of ongoing reclassification discussions given their high economic development levels, while certain countries have been reclassified from emerging to frontier market status following deterioration in their market accessibility characteristics.
Frontier markets represent a sub-category of less developed markets that are too small, too illiquid, or have too many restrictions on foreign investment to qualify for full emerging market classification. Countries including Vietnam, Nigeria, Bangladesh, Kenya, and Kazakhstan are among those classified as frontier markets. Frontier markets offer potentially higher return potential reflecting their earlier stage of economic development but carry higher liquidity risk, higher political risk, and lower transparency than emerging markets.
The Economic Case for Emerging Market Investment
The investment case for emerging markets rests on several interconnected economic arguments that together suggest these markets can offer attractive long-term return potential, diversification benefits, and exposure to global growth dynamics unavailable in developed market portfolios alone.
The growth differential between emerging and developed economies is the most fundamental element of the investment case. Emerging market economies have historically grown at rates significantly higher than developed market economies, reflecting the catch-up dynamics of countries that begin from a lower base of economic development and can adopt existing technologies, management practices, and institutional frameworks more rapidly than they were originally developed. Countries with lower capital-to-labour ratios can generate higher returns on new capital investment than more capital-abundant developed economies, supporting higher GDP growth rates. Countries with younger populations have higher proportions of their people in the workforce, supporting both productive capacity and consumer spending growth. Countries in the process of urbanisation see productivity gains as workers move from lower-productivity rural agricultural activities to higher-productivity urban industrial and services employment.
The expanding middle class in emerging economies represents one of the most powerful secular investment themes of the early twenty-first century. Hundreds of millions of people in China, India, Southeast Asia, sub-Saharan Africa, and Latin America are entering the middle class and becoming consumers of goods and services, including financial services, healthcare, education, consumer technology, and branded consumer products, that they previously could not afford. The companies best positioned to benefit from this expanding consumer base, both local companies with deep market knowledge and international companies with established brands and distribution networks, represent potentially attractive long-term investment opportunities.
The diversification benefit of emerging markets within a global portfolio reflects the imperfect correlation between emerging and developed market returns. Emerging market equity returns are driven by a different mix of economic factors than developed market returns, including commodity prices, currency movements, domestic consumption dynamics, and political developments specific to each country. The lower correlation between emerging and developed market returns during normal market conditions adds diversification value to a global portfolio, potentially reducing overall portfolio volatility without proportionally reducing expected return.
The Distinctive Risks of Emerging Market Investment
The higher expected returns of emerging market investments are not available without commensurate risks, and the risk profile of emerging market exposure differs materially from that of developed market investment in ways that must be carefully understood and managed.
Political risk is the most fundamental and most distinctive risk of emerging market investment, encompassing the wide range of ways in which political developments, government decisions, and changes in the political environment can adversely affect the value of investments. Political risk includes the risk of expropriation or nationalisation of privately owned assets by a government, the risk of adverse regulatory changes that disadvantage foreign investors or specific industries, the risk of civil unrest or armed conflict that disrupts economic activity and financial markets, the risk of unfavourable changes in tax policy or capital controls that restrict the repatriation of profits and investment capital, and the risk of corrupt or capricious legal systems that do not reliably enforce property rights and contract obligations.
Currency risk is pervasive and significant in emerging market investment. Most emerging market countries have currencies that are less liquid, more volatile, and more subject to episodes of sharp depreciation than the currencies of major developed economies. Currency crises, in which an emerging market currency rapidly loses a large fraction of its value against major developed market currencies, have been a recurring feature of emerging market financial history, with major currency crises in Mexico in 1994, across Southeast Asia in 1997 and 1998, in Russia in 1998, in Brazil in 1999, in Argentina in 2001 and 2002, and numerous other episodes since. A foreign investor who holds emerging market equity or debt denominated in a local currency that subsequently depreciates sharply against their home currency will sustain losses on the currency component of their return that partially or entirely offset any gains on the underlying investment.
Liquidity risk in emerging markets is meaningfully higher than in developed markets, particularly during periods of market stress. The investor base in many emerging markets is smaller and less diversified than in developed markets, the secondary market trading infrastructure is less developed, and the proportion of the market held by foreign investors who may withdraw capital during global risk-off episodes can be higher. During periods of global financial stress, foreign investors often withdraw from emerging markets simultaneously, creating correlated selling pressure that reduces liquidity and amplifies price declines precisely when liquidity is most needed.
Governance and transparency risk reflects the generally lower standards of corporate governance, financial reporting, and regulatory disclosure in many emerging markets compared to the standards prevailing in major developed markets. Less rigorous accounting standards, less effective securities regulation, weaker enforcement of minority shareholder rights, and higher prevalence of related-party transactions between controlling shareholders and the companies they control can all disadvantage foreign minority investors who lack the information and legal recourse available to investors in more transparent markets.
Macroeconomic volatility in emerging economies is generally higher than in developed economies, reflecting less mature monetary policy frameworks, less diversified economic structures, greater dependence on commodity exports or other concentrated sources of foreign exchange earnings, higher susceptibility to external shocks from developed economy monetary policy changes or commodity price movements, and in some cases less independent central banks and fiscal authorities. Higher macroeconomic volatility translates into higher volatility of corporate earnings and financial market returns, requiring investors with longer time horizons and greater risk tolerance than developed market investment demands.
Emerging Market Equities
Emerging market equity investment provides ownership exposure to companies operating in or deriving their revenues from emerging market economies. The emerging market equity opportunity set has expanded dramatically over the past three decades as the number of publicly listed companies in emerging markets has grown, as those companies have grown in size and sophistication, and as financial market reforms have improved the accessibility of these markets to foreign investors.
The composition of the emerging market equity opportunity set has shifted significantly over time, reflecting the evolution of emerging economies themselves. In the 1990s, emerging market equity indices were dominated by commodity-producing companies and state-owned enterprises in industries including oil and gas, mining, steel, and telecommunications. Today the emerging market equity universe is more diversified and includes large, globally significant technology platforms, consumer companies, financial services groups, and healthcare businesses alongside the traditional resource and infrastructure companies.
China represents the largest single country weight in the MSCI Emerging Markets Index and is the dominant force in emerging market equity performance. The dramatic growth of China's economy over the past four decades has created a universe of large, sophisticated, and increasingly globally competitive companies across a wide range of industries. However China also presents distinctive risks including the opacity of corporate governance in state-influenced entities, the regulatory unpredictability demonstrated by the 2021 crackdown on the technology and education sectors, the geopolitical tensions surrounding Taiwan and trade relations with Western countries, and the concentration of the investment opportunity in a small number of very large internet and technology platforms whose valuations reflect high expectations.
India represents the second-largest emerging market economy and the second-largest weight in major emerging market indices. India's investment case rests on its large and young population, its rapidly growing middle class, its democratic political institutions, its English-language tradition that facilitates business and technology integration with the global economy, and the dynamism of its technology and financial services sectors. India's equity market has delivered strong returns over the past decade and commands premium valuations reflecting investor enthusiasm for these structural growth drivers.
Emerging Market Fixed Income
Emerging market fixed income encompasses both the sovereign debt issued by emerging market governments and the corporate debt issued by emerging market companies, in both foreign currencies, primarily US dollars and euros, and local currencies.
Hard currency emerging market debt, denominated in major developed market currencies, provides investors with credit risk exposure to emerging market sovereign and corporate issuers without the currency risk of local currency investment. The JP Morgan EMBI Global Diversified Index is the most widely referenced benchmark for hard currency emerging market sovereign debt. Hard currency bonds are accessible to a broader range of institutional investors because they eliminate the operational and hedging complexity of local currency exposure, and they trade in deeper and more liquid markets than most local currency alternatives.
Local currency emerging market debt, denominated in the currency of the issuing country, provides exposure to both the credit quality of the issuer and the performance of the local currency. The JP Morgan GBI-EM Global Diversified Index is the primary benchmark for local currency emerging market government debt. Local currency debt offers the potential benefit of currency appreciation if the local currency strengthens against the investor's home currency, but it also carries the risk of significant losses if the local currency depreciates. Local currency emerging market debt provides genuine portfolio diversification because its returns are driven by a different set of factors than either developed market fixed income or hard currency emerging market debt.
The yield differential between emerging market bonds and comparable developed market government bonds, often called the emerging market spread, compensates investors for the higher credit risk and lower liquidity of emerging market debt. This yield premium has historically been substantial, reflecting the genuine default risk of some emerging market issuers as evidenced by the numerous sovereign defaults and restructurings that have occurred across emerging markets over the past five decades.
The Impact of Developed Market Monetary Policy on Emerging Markets
One of the most important and most consequential external drivers of emerging market financial conditions is the monetary policy of major developed market central banks, particularly the US Federal Reserve. The relationship between Fed policy and emerging market conditions is sometimes described as the original sin of global finance, reflecting the structural vulnerability of many emerging economies to changes in the cost and availability of dollar-denominated financing.
When the Federal Reserve tightens monetary policy by raising interest rates and reducing its balance sheet, the consequences for emerging markets are typically adverse and operate through multiple channels. Rising US interest rates make dollar-denominated assets more attractive relative to emerging market assets, encouraging capital flows from emerging markets back to the United States. A stronger dollar that often accompanies Fed tightening increases the real burden of dollar-denominated debt for emerging market borrowers who earn revenues in local currencies. Higher global borrowing costs increase the interest expense of emerging market sovereigns and corporations that have financed themselves in international debt markets.
The taper tantrum of 2013, in which the mere suggestion by Federal Reserve Chairman Ben Bernanke that the Fed might begin reducing its bond purchase programme caused sharp sell-offs across emerging market currencies, bonds, and equities, illustrated the dramatic sensitivity of emerging markets to changes in Fed communication and policy expectations. The aggressive Fed tightening cycle beginning in 2022 again created significant headwinds for emerging markets, contributing to currency weakness, capital outflows, and rising local interest rates across a broad range of emerging economies.
Investing in Emerging Markets: Vehicles and Approaches
Individual and institutional investors access emerging market exposure through a range of vehicles and approaches, each with distinct cost, liquidity, and implementation characteristics.
Passive index funds and exchange-traded funds tracking the MSCI Emerging Markets Index or similar benchmarks provide low-cost, diversified exposure to the full universe of emerging market equities accessible to foreign investors. These vehicles are appropriate for investors who accept the composition and weighting of the index as a reasonable representation of the opportunity set and who prioritise cost efficiency and transparency over the potential outperformance of active selection.
Active emerging market equity managers argue that the greater information asymmetries, less mature analyst coverage, more frequent corporate governance issues, and higher dispersion of returns in emerging markets create more favourable conditions for skilled active management than in highly efficient developed markets. The evidence on active emerging market manager outperformance is more positive than in developed markets, with a higher proportion of active managers generating positive alpha over long periods, though the majority still underperform after fees.
Country-specific or regional funds provide concentrated exposure to a single emerging market country or geographic region, allowing investors to express specific views on the investment attractiveness of particular countries while accepting the concentration risk of a less diversified exposure. Country-specific ETFs covering markets including China, India, Brazil, South Korea, Taiwan, and many others are widely available and trade on major US exchanges with good liquidity.
American depositary receipts and global depositary receipts on major emerging market companies traded on US and European exchanges provide access to individual emerging market companies within a familiar regulatory and trading environment, though the universe of companies available in this form is limited to the largest and most internationally recognised names in each market.
Examination Relevance and Key Takeaways
Emerging markets are tested on the Series 65 examination in the context of global investing, portfolio diversification, country and political risk, currency risk, and the characteristics of different asset classes within the global investment universe. Candidates must understand the definition and classification of emerging markets, the economic rationale for including emerging markets in a diversified portfolio including the growth differential and diversification benefit, the distinctive risks of emerging market investment including political risk, currency risk, liquidity risk, governance risk, and macroeconomic volatility, and the major vehicles through which investors access emerging market exposure.
The core points to retain are these: emerging markets are economies in transition toward the characteristics of developed markets with higher growth potential but higher risk; MSCI classifies countries based on economic development, market accessibility, and market size and liquidity with China, India, Brazil, Taiwan, and South Korea among the largest constituents; the investment case rests on higher economic growth rates, expanding middle class demographics, and diversification benefits from imperfect correlation with developed markets; the distinctive risks include political risk including expropriation and regulatory unpredictability, currency risk from volatile local currencies, liquidity risk that amplifies during global stress episodes, governance and transparency risk from weaker corporate governance standards, and macroeconomic volatility from less mature policy frameworks; Federal Reserve monetary policy has a powerful and often adverse effect on emerging markets through capital flow dynamics and dollar strength; and passive index funds and ETFs provide low-cost diversified access while active managers may add more value in emerging than in developed markets given greater information asymmetries.
