The Saturday Story: Pitfalls of investing in emerging markets

In theory, investing in the emerging markets of small, under-developed countries will give better returns than conventional ones. Nic Cicutti, Personal Finance Editor, looks at the potential pitfalls.

Earlier this month Save & Prosper, a UK investment management company, flew a bevy of journalists to Moscow. Amid toasts of vodka, the visit aimed to convince the scribes of the wonderful investment opportunities available in the former Soviet Union, where S&P has launched a new fund.

But the timing was dreadful. On Red Tuesday this week, as equity prices collapsed, Russia's ASP general share index plummeted by 19 per cent, the worst fall of any market that day. By contrast, the Dow Jones rose by 4.7 per cent, while the index of top 100 UK companies in London fell by 1.76 per cent.

The Russian example illustrates a dilemma for investors: how can they hope to out-perform returns generally available from equity markets? For increasing numbers of savers, the answer has been to look to emerging markets.

These are typically seen as developing stock markets where rapid development can lead to spectacular growth and, therefore, spectacular returns. The International Finance Corporation, part of the World Bank, says there are four main regions : Latin America, Asia, Eastern Europe and "others", which include Africa, the Middle East and some Mediterranean countries. There are vast differences between these markets, which range from India to Greece, Indonesia to Kenya, Hungary to Brazil.

But what marks them all out is the perception that they are going through vast economic or political upheavals out of which those with an inside track can benefit. Foreign investment allows companies in those countries to develop far more rapidly than otherwise. In turn, cheap shares in infant companies can grow exponentially in value and the market as a whole can benefit: in Russia, for example, the stock market leapt by around 100 per cent in the first six months of this year.

The potential attractions of emerging markets have meant a lot of funds from the UK and US have gone to these countries. From Britain, according to the HSW financial statistics provider, more than pounds 2.5bn is invested in a range of unit and investment trusts specialising in these high-risk funds.

But risk has its potential downside. Emerging stock markets often operate in unstable environments and are therefore very unstable. This, coupled with illiquidity and difficulty matching buyers to sellers of shares, means investors can get burnt easily: as markets collapse they may find they cannot even dispose easily of their stock as it drops heavily in value. One effect of the financial traumas infecting emerging markets is the rapidity with which they can leap to more developed economies, in this case Hong Kong, mutating into full-blown collapses even in mature markets such as the US. In turn, these feed back to the developing economies.