Emerging market investing: risk, return, and how developing-economy exposure behaves in a portfolio
Emerging markets are economies that are developing economically and financially relative to developed markets—higher expected growth rates, evolving institutional frameworks, and less mature capital markets. MSCI classifies 24 countries as emerging markets, including China, India, Brazil, South Korea, Taiwan, and South Africa, covering approximately 12% of global equity market capitalisation. Emerging market investing offers access to faster-growing economies and industries that are underrepresented in developed market indices—but it comes with materially higher risk across multiple dimensions: higher volatility, currency exposure, political and institutional risk, and lower liquidity.
The risk and return profile
Emerging market equities have historically offered a return premium over developed market equities over very long periods, reflecting compensation for the additional risks borne. The Dimson-Marsh-Staunton global investment returns database and MSCI data show that emerging market equities have delivered higher volatility than developed market equities by a factor of approximately 1.5 to 2×, depending on the period measured. Drawdowns during global risk-off episodes—the 1997 Asian financial crisis, the 2008 global financial crisis, the 2020 COVID sell-off—have typically been deeper and more sustained in emerging markets than in developed markets, as capital flows out of risky assets in periods of global stress.
At the same time, the long-run return premium has been inconsistent across periods. Emerging markets outperformed significantly during the commodity supercycle and global growth expansion of the early 2000s, then underperformed for most of the decade from 2011 to 2021 as the dollar strengthened and the commodity cycle turned. The premium, like all risk premia, requires patience and tolerance for extended periods of underperformance.
Currency risk
Emerging market equity returns are denominated in local currencies—Brazilian reais, Indian rupees, Chinese renminbi—which are then converted to the investor's base currency. This introduces a second layer of risk beyond equity price movements: the exchange rate between the local currency and the investor's base currency. Emerging market currencies tend to be more volatile than developed market currencies and tend to depreciate against the US dollar and other reserve currencies during global risk-off episodes, amplifying equity losses at exactly the point when investors can least afford additional losses.
Currency hedging for emerging market equity exposure is technically possible but expensive—the cost of hedging reflects the interest rate differential between the emerging market currency and the investor's base currency, which can be substantial. Many investors in emerging market ETFs accept unhedged currency exposure as part of the asset class profile. See currency risk in international investing for the mechanics.
Political, regulatory, and institutional risk
Emerging markets carry political and regulatory risks that are largely absent in developed markets. Changes in government policy—capital controls, nationalisation, changes in foreign ownership rules, regulatory intervention in specific sectors—can produce sharp and sudden losses in individual country allocations. China's technology sector regulatory crackdown in 2021 reduced the valuations of major Chinese technology companies by 60% to 80% in some cases, within months. Investors in broad emerging market indices were materially affected because Chinese equities represented approximately 30% to 35% of the MSCI Emerging Markets Index at the time.
This concentration risk—where a small number of countries or sectors dominate the index—means that investors in emerging market index ETFs should understand the index's country composition and be aware of large single-country exposures. An MSCI EM ETF is not a diversified bet across 24 countries weighted equally; it is a market-cap-weighted index where a handful of large markets—China, Taiwan, India, South Korea—account for a large fraction of the total.
Portfolio sizing
Emerging markets represent approximately 12% of global equity market capitalisation. A global equity portfolio that tracks the MSCI All Country World Index (ACWI) will have approximately this allocation automatically. Investors who wish to hold less than market weight—because of their risk tolerance, currency concerns, or political risk preferences—should note that they are making an active bet against the full-market-cap weight. Conversely, investors who overweight emerging markets are expressing a view that the expected return premium justifies the additional risk in their specific portfolio context.
See home bias in investing for the related behavioural tendency to underweight foreign markets, which often results in inadvertent underexposure to emerging markets as well as developed international markets.
Limitations
The historical return data for emerging markets has significant limitations. The MSCI Emerging Markets Index was launched in 1988, meaning the full dataset covers fewer than 40 years—insufficient to draw reliable long-run conclusions about the premium's magnitude and variability. The composition of the index has changed substantially over this period, with China in particular moving from negligible representation to a major weight. Returns for countries before their inclusion in the index are not captured, creating survivorship bias in the historical performance record.
Emerging market investing in pfolio
pfolio's asset universe includes emerging market equity ETFs, providing access to broad EM exposure and to specific regional or country allocations within the EM universe. Asset details and performance metrics are visible at pfolio Assets and in pfolio Insights—Equity.
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