Emerging markets: A premium, paid for uncertainty

Emerging countries often have the strongest growth. So why don't their stock markets always beat the others?

Because investing there means carrying risks rarely seen in developed markets. And those risks have a price.

First principle: the risk premium. An investor only accepts more uncertainty if they hope to be paid more.

Say seven per cent expected on a large developed market. For an emerging one, you need more, say nine.

Those two extra points are not a gift. They are the price of nasty surprises. And sometimes, they happen.

Second risk: politics. A government can change the rules of the game overnight.

Capital controls: you still have the right to own, but no longer to take your money out of the country.

In two thousand twenty-two, after the invasion of Ukraine, foreign investors found themselves stuck in Russia.

The major indices removed Russian shares at a price of almost zero. For many funds, that share was almost entirely lost.

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There is also expropriation: the state takes back a company or an oil field. Venezuela did it with oil projects in two thousand seven.

Third risk, more technical, but formidable: debt in a hard currency.

Many emerging countries and companies borrow in dollars. Lenders do not want their currency.

Economists gave a name to this difficulty borrowing in your own currency: original sin.

Say a debt of one hundred million dollars, when one dollar is worth ten units of local currency. That is one billion units.

If the local currency loses half its value, the dollar is worth twenty. The same debt weighs two billion.

Income stays in local currency. That is the trap that snapped shut during the Asian crisis of nineteen ninety-seven.

Last risk, often forgotten: concentration. An emerging index includes dozens of countries.

But a few make up most of it: China, India, Taiwan and South Korea weigh more than two thirds. The weights shift every year.

So buying "emerging markets" mostly means betting on four countries. And on their governments' decisions.

None of this rules out investing there. But you know what you are buying: a premium, paid for uncertainty.

And you only collect a premium if you hold on. For a long time, with a share you can afford to see fall.