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:
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 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.
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.
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).
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.