The pitch for emerging markets investing has barely changed in thirty years: young populations, fast-growing middle classes, urbanisation and catching-up productivity. All of that is real. So is the experience of investors who have watched a country's economy boom while their portfolio in that country went nowhere, or lost half its value overnight in a currency crisis. Emerging markets can be rewarding, but the link between economic growth and investor returns is far weaker than most people assume. Here is what actually drives returns – and what tends to wipe them out.
What counts as an emerging market
There is no single legal definition. Index providers such as MSCI and FTSE Russell classify countries using criteria like income levels, market size, liquidity, openness to foreign capital and the reliability of the market's operations. The big names usually include China, India, Taiwan, South Korea, Brazil, Saudi Arabia, South Africa and Mexico, though classifications differ between providers and change over time. Smaller, less accessible markets are often grouped as "frontier" markets.
The label covers enormous diversity. A fund tracking an emerging markets index can be dominated by a handful of large Asian economies and a few huge technology and financial companies, while dozens of other countries make up a small share.
The opportunities in emerging markets
- Faster economic growth. Many emerging economies grow faster than developed ones because they are catching up in infrastructure, productivity and technology.
- Demographics. Countries with younger populations can see rising consumption and labour supply for decades.
- Valuation. Emerging market shares have often traded at lower valuations than US stocks, which can mean higher expected returns if risks do not materialise.
- Diversification. Different economic cycles, commodity exposure and policy settings mean emerging markets do not always move with developed ones.
- Access to global champions. Some of the world's most important companies – in semiconductors, e-commerce and manufacturing – are listed in emerging markets.
Why GDP growth does not equal stock returns
This is the counterintuitive part. Several reasons explain why a fast-growing economy can deliver poor returns to shareholders:
- Dilution. Growth is often funded by new share issuance and new listings. The economy grows, but existing shareholders own a shrinking slice.
- Who captures the profits. Growth may flow to private companies, state enterprises or foreign multinationals that are not in the investable index.
- Price already paid. If everyone expects strong growth, it is reflected in valuations at the outset.
- Governance. Weak minority shareholder protection lets controlling shareholders or the state capture value.
- Currency. Even strong local-currency returns can shrink once converted back to dollars, euros or pounds.
The lesson: invest in emerging markets for the returns companies can deliver to minority shareholders, not for the GDP headline.
Currency risk in emerging markets investing
For a foreign investor, every emerging market investment is two bets: the asset and the currency. Emerging market currencies can fall sharply when:
- The US dollar strengthens, making dollar-denominated debt more expensive to service.
- US interest rates rise, drawing capital back to safer markets. The 2013 "taper tantrum", when markets reacted to signals that the Federal Reserve would slow its bond buying, hit several emerging currencies hard.
- Countries run large current account deficits and depend on foreign capital to fund them.
- Inflation runs high and the central bank loses credibility.
- Commodity prices fall for exporters of oil, metals or agricultural goods.
Economists use the term "original sin" for the difficulty many emerging economies have had borrowing abroad in their own currency. When debts are in dollars and the local currency collapses, the debt burden balloons. The 1997 Asian financial crisis, which began with Thailand's devaluation, is the classic case.
Political and governance risk
Political risk in emerging markets is not only about elections or coups. It includes:
- Sudden regulatory shifts that reprice whole sectors.
- Capital controls that make it hard to move money out.
- Sanctions – when Russia invaded Ukraine in 2022, Western investors in Russian assets found them effectively frozen, and index providers removed Russia from their emerging markets indices.
- Expropriation or nationalisation of companies or resources.
- Sovereign default. Russia in 1998 and Argentina in 2001 are well-known examples, and debt restructurings are not rare.
- State-owned enterprises that serve policy goals before shareholder returns.
These risks are hard to model and tend to arrive suddenly, which is why diversification across countries is so important.
How to invest in emerging markets
| Approach | Pros | Cons |
|---|---|---|
| Broad EM index fund or ETF | Cheap, diversified across countries | Concentrated in largest markets; you take the index's weights |
| Active EM fund | Can avoid weak governance, adjust country weights | Higher fees; many active funds do not beat their index over time |
| Single-country fund | Targeted view | Concentrated political and currency risk |
| EM bonds (hard or local currency) | Income; hard-currency bonds reduce FX risk | Credit and default risk; local bonds add FX risk |
| Developed-market companies with EM revenue | Familiar governance | Indirect exposure, diluted by home markets |
A practical checklist
- Decide what role emerging markets play in your portfolio and size it accordingly.
- Look at the actual country and sector weights of any fund you buy.
- Understand whether your exposure is hedged or unhedged to currencies.
- Watch the US dollar and US interest rates – they often matter more than local news.
- Expect long periods of underperformance as well as sharp rallies.
- Prefer diversification across many countries over concentrated bets.
Emerging markets investing rewards patience and punishes overconfidence. The growth story is real, but returns depend on currencies, governance and the price you pay. Go in knowing the risks, size them honestly, and the opportunities become easier to hold through the bad years.
This article is for education only and is not financial or investment advice.
