Emerging and frontier markets are where most of the excitement is in international investing. Because they are growing much faster than the developed world (at this writing, they represent about 8 percent of global market capitalization), there are more opportunities to make money—but also more opportunities to lose it.
It's useful to think of emerging markets as being analogous to U.S. microcap stocks. The sector is very inefficient, and hard work—and shoe leather—can pay off. On the other hand, with emerging markets you not only have to do serious work on individual companies, you also have serious geopolitical risk. Many investors in emerging markets are “hot money,” people who have piled into the sector because recent returns have been strong. But when the market turns, these people bail out quickly, driving the markets down even further. Capital flight is a huge problem for emerging economies.
Because of the many challenges associated with emerging markets, many people either index11 this sector or they go in the opposite direction, gaining their exposure via long/short hedge funds that typically exhibit huge tracking error against the MSCI Emerging Markets Index. There is, in other words, a lot of skepticism that traditional active managers can add much value in emerging markets, and it's a skepticism that I share.
While every long-term investor should have something like an 8 percent to 10 percent position in emerging markets, ...