Steadfast FinancesWhy Investing in Emerging Markets Can be Dangerous

Why Investing in Emerging Markets Can be Dangerous

Filed in ETFs , Index Funds , Investing 101 , Risk Management 11 comments

Earlier this week, everyone’s favorite emerging market — Brazil — gave a classic example of why it can be dangerous to invest in emerging markets. Out of the blue, the Brazilian government implemented a 2% tax on any incoming foreign investment to reduce the possibility of a speculative stock market bubble from forming in the Bovespa.

Thus, the emerging market which could do no wrong, has a vast supply of untapped commodities, as well as a stable currency, will require you to pay a 2% fee for just playing along. If only they had decided to take 20% of your profits, they would be the world’s largest hedge fund.

While the news only caused a small 4% drop in the Bovespa and the iShares MSCI Brazilian Index ETF (NYSE: EWZ), the unexpected policy change exemplifies a few basic dangers of investing in emerging markets that most people here in the United States sometimes forget:

  1. Their way of doing business might not be our way of doing business.
  2. Their government isn’t like the U.S. Government, and can implement a policy change on a whim.
  3. They don’t require the “Western World’s” approval.
  4. They have their best interests in mind. Not ours. Not yours.
  5. They will do whatever they darn well please in their own country. If you don’t like it, [bleep] off!

Granted, most well respected emerging market countries will conduct themselves in a manner to attract foreign investors, but there are a few countries who go out of their way to make things difficult for foreign investors for any number of reasons (e.g. greed, political verification, etc).

Russia

Russia and the U.S. have had their differences, but after the Cold War, the Russian business climate appeared to have warmed to receiving American Dollars and a western economic system. However, that doesn’t mean they don’t want to conduct business according to Russian “rules” where organized crime is rampant and the Russian government has the muscle to strong arm any corporation located on its native soil.

Take the case of Bill Browder, CEO of Hermitage Capital Management, where his firm’s offices were raided, servers and computers seized, all documents and finances confiscated, etc. Basically, the worst possible situation you can have when conducting business on foreign soil.

CNBC has brought up the subject many times over, and it’s not just U.S. investors who are questioning whether doing business with Russia is worth the financial risk.

Venezuela

Hugo Chavez is one of the world’s most infamous heads of state. His thoughts have the potential to be converted into law in a very short time period since he has access to the Venezuelan military.

Not to mention, he is notoriously whimsical and has an unfortunate tendency to nationalize any private property built on Venezuelan soil that he might find is “good for the Venezuelan people”. So if you’re a private corporation thinking about building a factory in Caracas or maybe setting up an offshore oil platform in Venezuelan waters, you might end up losing a cool half billion dollars just because Chavez thinks he’s entitled to it.

Iraq

War torn Iraq could arguably be one of the most hostile and unsafe countries in the world. For that reason alone, it would seem unlikely that Iraq could attract any semblance of foreign investment.

But considering the strong western influence (e.g. a military presence) that will likely be there for many years to come, some would argue that the risk reward ratio has become attractive considering that the peace will be (forcibly) maintained and a business friendly government has been put in place.

The danger is real, but the potential ROI is apparently big enough to entice the big fish (e.g. hedge funds).

Safest Way to Invest in Emerging Markets

If you’re a U.S. based investor, you have a growing number of mutual funds, index funds and ETFs at your fingertips.

Like anything, just because you can quickly find what you need doesn’t mean you should invest in any single emerging market considering the elevated risk. Much less a frontier market in a country like Iraq where even major hedge fund investors are following heightened risk management procedures and only allocating 1% or less in one specific country.

That said, if you’re determined to move forward, the safest way to invest in the emerging markets would likely be a Plane Jane emerging markets index fund or ETF. This way, the risk is spread out over a broad range of countries so taking a hit due to one country’s negative news (e.g. Brazil’s 2% foreign investor tax) won’t result in a substantial loss of capital within a short time frame. Of course, by investing in an index fund or ETF that tracks a foreign market index, you lower your risk by diversifying your investment but also lower your profit potential.

Investment management firms like Vanguard, Charles Schwab and Fidelity would all be suitable to find low cost emerging market investment vehicles.

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Posted by CJ   @   20 October 2009 11 comments
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11 Comments

Comments
Oct 21, 2009
1:19 pm

As I understand it, Brazil’s move was a reaction to the quick weakening of the USD – one of the possible strategies for trying to “weaken” their own currency without really weakening it. Keeps more speculative dollars out of their market and pushing up the real even more. Australia took a different tack.

So it’s all interrelated – it’s not like Brazil is some irrational place trying to screw foreign investors. It’s probably a wise decision on their part. Just my two cents.

Oct 21, 2009
1:26 pm
#2 Matt SF :

I think it’s a very wise decision. No one wants a speculative bubble, especially when it’s in your own country (and you have to clean up the mess). When you consider that 1/3 of new investments are from non-Brazilian entities, you can see their concern.

Not to mention, it’s a pretty good way of generating additional tax income to pay for the 2016 Olympics!!!

It’s like a sin tax for speculators. (sly grin)

Oct 21, 2009
2:41 pm
#3 Matt SF :

Thanks Neal. Coming from you, that’s saying something!

Oct 25, 2009
12:05 am

Ahh, my favorite topic. If you’re a bird and you look at the growth of the world, you see Emerging Markets as the place to be.

If there are those who don’t speak Chinese yet, better start a learning! :)

FS

Oct 25, 2009
12:10 am
#5 Matt SF :

Hey no argument there. I’m a firm believer in the Chimerca thesis.

I just wanted to give potential emerging markets investors a “moment of pause” before jumping on the bandwagon. The potential rewards are huge, but the risk shouldn’t be overlooked.

Oct 25, 2009
12:20 am

Hey Matt – It’s really cool you trade for a living. I’ve tried aggressively trading before, and usually it doesn’t pan out for me at the end of the year. I only got lucky back in 2000, and since then, it’s been a bunch of wasted time.

I’m in the industry and have a very intimate knowledge of a certain part of the emerging markets space. Too bad I’m not allowed to comment on specifics due to compliance reasons which I take very seriously.

I’m pretty petrified of where valuations are today so I have minimal exposure to equities. I am a believer in the economic recovery though.

I look forward to following your tweets and seeing you on FS one day.

Oct 25, 2009
12:49 am
#7 Matt SF :

Thanks for the comments FS. Trading was always something I wanted to try, and it’s worked out fairly well, but it’s probably the least fulfilling thing I’ve ever done. Sitting around clicking buy and sell is much like my former career as a consultant… you never really get the benefit of building anything substantial or seeing a project come full circle. It’s really just about keeping score, and having a higher score at the end of the month.

Funny you mention valuations. I heard a guy on CNBC a few days earlier this week mentioning P/E’s and I had to laugh since that “archaic” concept appears to have faded away in this rally. It’s made me look like an idiot b/c I thought we would have topped out by now, but it’s foolish to fight the tape.

See you on FS. I’ll be sure to pick your brain about emerging markets.

Feb 13, 2010
10:09 pm

I don’t really agree that the best way to tackle a challenging investment arena like emerging markets is through ETFs or passive index funds. The risks you highlight seem like those perfectly suited to be addressed by an active asset manager. Someone like US Funds is a manager who’s expertise lies in emerging markets.

Feb 14, 2010
1:00 pm
#9 Matt SF :

That’s certainly a worthwhile possibility, as long as the active manager can consistently outperform their benchmark indices and earn the higher fees they charge.

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