Young & Invested: Should you invest in emerging markets?
Renewed investor interest raises the case for diversifying beyond developed markets.
Mentioned: iShares MSCI Emerging Markets ETF (AU) (IEM)
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 31
Following a simple investment strategy can be a blessing and a curse.
I find myself constantly swinging between intense FOMO and waves of clarity and peace of mind as I stick to my plan. It helps temper my behaviour when the market noise gets loud.
The temptation to chase performance is very real, but so is the risk of straying too far from a strategy designed to achieve your goals. Logging into your brokerage account shouldn’t feel like scrolling Sportsbet. Nevertheless, this job has made me attune to changes in investor interest and shifts in market sentiment.
Lately, I’ve noticed a renewed curiosity about emerging markets amongst both professional and retail investors. With uncertainty often comes allure, especially when you’re young. In this week’s edition of Young & Invested, I dive under the chaos of debt defaults and political risk to unpack the elusive emerging market space.
What are emerging markets?
Emerging markets (EMs) or developing markets are countries that are undergoing economic transition with increasing standards of living. The most widely recognised benchmark is the MSCI EM Index which contains India, South Korea and China among other countries. The table below reflects MSCI’s current classification by region.
Figure 1: Emerging market classification. MSCI. 2025.
However, EMs are not to be confused with frontier markets, which as the name suggests, are on the cusp of becoming emerging markets e.g. Vietnam and Argentina. They are loosely categorised by having lower market capitalisation and liquidity than traditional EMs, as well as being further along the risk and sophistication scale for investors.
Perception of such markets often shift cyclically from risky and disappointing to dynamic and exciting, despite their classification remaining relatively fixed.
Why do people invest in EMs?
EM economies account for over half the world’s GDP, yet their combined equity market capitalisation is merely ~15%.
According to the International Monetary Fund, EMs are expected to grow at nearly twice the pace of developed economies in the coming years, driven by their transition to a modern industrial economy. Thus, the market subsect can paint a compelling picture on long-term growth prospects.
Despite this, investors haven’t always been able to capture the upside due to challenges with corporate governance, political instability and limited transparency. For those willing to navigate the risks, exposure to geographies where economic growth outpaces that of developed markets, theoretically offer higher returns (often at higher volatility).
Secondly, international exposure is usually one of the first steps towards a diversified portfolio. From this perspective, most international equities benchmarks, especially those in developed markets, have been closely tied to the US over the past three years. Meanwhile, EM stocks tended to have lower correlations with US stocks.
Figure 2: Three-year correlation matrix: International equity. Morningstar 2025 Diversification Landscape.
But what drives this?
Firstly, the industries prominent in EMs (energy and basic materials) have declined as a portion of the US market. In addition, the Chinese economy (~30% of major EM benchmarks), follows a different economic cycle than the US.
Finally, EMs are more likely to be affected by country and region-specific geopolitical events – political instability, wars, and currency devaluations – that have little to do with the US. Collectively these features suggest that EM equities’ low correlation with US stocks won’t be as fleeting as other correlation trends.
Along with investors seeking diversification and higher economic growth, EMs offer lower valuations. Historically they’ve traded at a discount to developed markets, despite their improving fundamentals and rising credit quality. From this standpoint, EM equities are at their most attractive level in more than two decades.If the discount is justified is up for debate.
Figure 3: Why the fortunes of emerging markets may be improving. White paper. Wasatch Global Investors. 2025.
Recently there have been several factors driving renewed interest in EMs.
Currency headwinds – a commonly cited cause of EM underperformance – appear to be dissipating. The US dollar cycle has historically coincided with cycles of developed market and EM outperformance. Stronger periods of US dollar performance have correlated with weaker EM performance. Concerns about a weakening US dollar driven by political uncertainty and higher inflation has led investors to reconsider EMs.
Furthermore, there has been an overarching market narrative on the decline in US exceptionalism, leading investors to other developed nations as well as EMs.
How to gain exposure
Accessing EMs as an individual investor can be complex and costly due to legal and administrative obligations. It can also be difficult to research companies due to limited information and different accounting rules.
Collective investment vehicles like funds and ETFs have democratised this process by professionalising security selection. Investors are comfortable with turning to professionals. According to AUSIEX, interest in EM exchange-traded products has increased with net flows in the first half of 2025 up 68% compared to the same period last year.
Are active managers more successful in emerging markets?
Conventional wisdom stipulates that active funds should have higher success rates in less efficient markets. But is this actually the case? Can active managers do the work for us (albeit at a higher cost)?
Our Active/Passive Barometer report measures the performance of active funds against passive peers in their respective categories, serving as a measuring stick to determine the odds of succeeding with an active approach.
Figure 4: Morningstar Active Passive Barometer. 2024.
The figure above shows active funds have a high success rate (62%) in the long term (10Y). Furthermore, the positive excess 10Y return (0.4%) of the average active fund over the passive cohort is notable.
In comparison, the three and five year performance appears underwhelming. This is explained by a passive outlier – the multifactor ETF (which I’ve previously explored). This strategy overlays a rules-based selection process to an index, to determine which companies best reflect relevant factors. This approach heavily outperformed all other passive peers and skewed results.
Does a passive approach still work?
Barring the multifactor approach, passive EM ETFs and underlying benchmarks are widely considered inefficient for a plethora of reasons.
Firstly, EM ETFs are less capable of delivering benchmark returns than developed market ETFs. This can be partially attributed to the high number and relative illiquidity of holdings. For example, iShares MSCI Emerging Markets ETF IEM which tracks the MSCI Emerging Markets Index has consistently lagged the benchmark by ~1% over the long term.
Another reason is benchmark concentration, with China, Taiwan and India accounting for ~65% of the MSCI EM Index. Since the index is weighted towards large-cap stocks, smaller and mid-cap companies with more aggressive growth prospects (as sought by emerging market investors), are underrepresented.
For example, Baidu (China’s Google), was listed on the NASDAQ in 2005 and was added into the MSCI index in 2015. During 2005-2015, Baidu returned over 2000%. Active managers are no stranger to concentration either, but in theory it is likely due to their conviction being substantiated by fundamental research.
Additionally, index rules result in the inclusion of many EM companies that may be considered undesirable from an investment standpoint. It’s easy to assume that all index providers apply some element of quality screening to stocks to ensure they are of calibre. However, unlike the S&P 500, MSCI indices, including MSCI Emerging Markets do not have financial viability requirements, which may attract companies of poor quality and therefore detract from performance.
Finally, EMs feature a unique presence of state-owned enterprises (SEOs), which currently comprise ~20% of the MSCI Emerging Markets Index. These companies often prioritise other objectives over maximising shareholder value, and as a result, have historically underperformed non-SEOs.
Passive investing provides the pretext of diversification, but one should question whether having exposure to all nations at all times is desirable. EM countries should not be treated homogeneously given their differences.
Market inefficiencies should theoretically create opportunities for active managers to fare better than passive counterparts. Blindly tracking an EM index could mean you’re forgoing the alpha-generation potential associated with an inefficient market. However, given the varied success rates of active funds in this category, due diligence is required for either option.
Below is a screen I ran of EM ETFs covered by Morningstar that did not have a Neutral or Negative Medallist Rating.
Figure 5: Author screen for emerging market ETFs. Chartlab.
How have they performed?
Most Aussie investors carve out a portion of their portfolio for US exposure and may add a wider group of developed markets. Diversifying internationally past the US might make sense, but doing so has detracted from returns in recent times.
Figure 6: EM equities trailed DM equities after the GFC. MSCI. 2025.
Renewed investor interest is unsurprising given year to date performance for EMs has been comparatively higher than developed markets (20% vs 14%). However, from the figure above we see that EMs have trailed developed market equities since the GFC. MSCI estimates that this underperformance has been almost 5% annually.
Whilst it’s difficult to pinpoint one specific reason for this, it’s likely driven by the strength of the US dollar which reduces the return of EM equities when converted to dollars. Furthermore, an elevated USD drives up the cost of dollar-denominated debt servicing. This macro concern, coupled with a strong US market has likely triggered capital outflows.
Risks
This review wouldn’t be complete without focusing on risk. Despite favourable economic indicators, I think it’s safe to say that Aussie investors tend to overlook emerging markets. We’ve traditionally sidelined them due to a combination of unfamiliarity, volatility and perceived risk.
Not all EM countries are the same, but nevertheless, they introduce a unique set of risks compared to developed markets. These include political and economic instability. Debt default is a common concern given many EMs borrow in US dollars and can’t simply print money to repay loans. Currency risk also plays a major role with fluctuations impacting returns more severely than we see in developed markets. Currency-hedged alternatives are available but can come with higher fees.
For further insight into each of these risks, view our full Guide to Emerging Markets on Morningstar Investor.
Should young investors care?
We’re often told not to put all our eggs in one basket. Simple enough. But the point of portfolio diversification shouldn’t be to find assets that move in opposite directions. Finding non-correlated assets to hedge your portfolio simply doesn’t make sense for long-term investors with higher return objectives.
EMs have long been a staple for diversified portfolios, but younger investors might be particularly drawn to them as a source of high-growth potential, and thus willing to accept their short-term volatility in pursuit of higher long-term returns.
We tend to consider our asset allocation decisions in retrospect. I, like many others, wish I had invested in NVIDIA during high school instead of buying new Nikes every year. Hindsight is a wonderful thing.
Theoretically, emerging markets are the next developed markets. Anyone with 10, 20, 30+ years of investing ahead of them should consider whether recency bias plays a part in their allocation decisions. It’s important to be forward-looking, rather than simply seeking out investments that have delivered strong returns in the recent past.
There is no guarantee on the future outperformance of EMs, but their long-term growth prospects might make an attractive edition to a lifetime portfolio.
Ultimately, investments simply form part of a larger thesis. There are multiple opportunities and asset classes out there, but it doesn’t mean every one of them will be suitable for you.
