Em Cash: Investing Strategies For Beginners

Investing in emerging markets can be a great way to diversify your portfolio and gain exposure to companies in fast-growing countries with developing economies. These markets account for 80% of global growth and may provide higher returns than developed markets during robust economic growth. However, it's important to remember that emerging markets come with higher risks and volatility due to their reliance on commodity exports and the potential for geopolitical instability. Before investing, consider the potential risks and rewards and decide if a modest allocation of 5-10% in your portfolio is appropriate for you.

Weigh up the risks and returns

Weighing the risks and returns is a crucial aspect of investing. While investing in emerging markets can offer lucrative gains, it's important to carefully consider the associated risks. Here are some key points to help you weigh the risks and returns of investing in EM cash:

Risks of Investing in Emerging Markets:

• Foreign Exchange Rate Risk: Currency fluctuations can impact the total return of your investment. For example, if the local currency depreciates against your domestic currency, you may experience a net loss when converting your returns back.
• Non-Normal Distributions: Emerging market securities cannot be accurately valued using traditional mean-variance analysis due to the constant changes in these markets. This makes it challenging to utilise historical information for investment decisions.
• Lax Insider Trading Restrictions: Emerging markets may have less stringent regulations against insider trading, leading to market inefficiencies and extreme speculation.
• Difficulty Raising Capital: A poorly developed banking system can hinder firms' access to financing, resulting in a higher cost of capital and limiting their ability to undertake profitable projects.
• Poor Corporate Governance: Emerging markets may have weaker corporate governance structures, giving management or the government more influence than shareholders. This can impact the incentives for management to perform effectively.
• Increased Chances of Bankruptcy: Weaker accounting audit procedures and a lack of checks and balances in emerging markets can increase the risk of corporate bankruptcy.
• Political Risk: Emerging market businesses often face higher government intervention and are more susceptible to adverse government actions, political instability, and other factors such as tax increases or changes in market policy.

Returns of Investing in Emerging Markets:

• Higher Expected Returns: Emerging markets often offer higher expected returns due to their elevated economic growth rates.
• Diversification Benefits: Investing in emerging markets can provide diversification to your portfolio, reducing overall risk.
• Stronger Economic Growth: Many emerging markets have stronger economic growth potential due to their competitive advantage in exporting low-cost and raw goods, favourable demographics, and government investments in technology, infrastructure, and education.

General Risk and Return Considerations:

• Risk-Return Tradeoff: Investors aim to maximise returns while minimising risk. Higher-risk investments typically offer the potential for higher returns, but there is no guarantee of profits.
• Time Horizon: Investing for the long term can help mitigate the impact of short-term volatility and allow for a more diverse portfolio.
• Diversification: Spreading your investments across different asset classes and individual investments can help minimise risk and maximise returns.
• Risk Tolerance: Different investors have varying levels of risk tolerance. It's important to understand your own risk tolerance and make investment decisions accordingly.

Consider investing in American Depositary Receipts (ADRs)

American Depositary Receipts (ADRs) are negotiable certificates issued by a US depositary bank, representing a specified number of shares—usually one share—of a foreign company's stock. They are traded on US stock markets like any domestic shares. ADRs offer US investors a way to purchase stock in overseas companies that would not otherwise be available.

ADRs are priced and traded in US dollars and cleared through US settlement systems. They are also denominated in US dollars, which means that holders of ADRs realise any dividends and capital gains in US dollars.

ADRs are issued by a US bank that represents shares in foreign stock. These certificates trade on American stock exchanges.

There are two basic categories of ADRs: sponsored and unsponsored. A sponsored ADR is issued on behalf of the foreign company, with the bank and the business entering into a legal arrangement. The foreign company usually pays the costs of issuing an ADR and retains control, while the bank handles the transactions with investors. Sponsored ADRs are categorised by the degree to which the foreign company complies with Securities and Exchange Commission (SEC) regulations and American accounting procedures.

Unsponsored ADRs are issued without the involvement, participation, or even permission of the foreign company. In theory, several unsponsored ADRs for the same foreign company could be issued by different US banks. These offerings may also offer varying dividends.

ADRs are also categorised into three levels, depending on the extent to which the foreign company has accessed US markets. Level I ADRs are only found on the over-the-counter market and have the loosest requirements from the SEC. Level II ADRs can be used to establish a trading presence on a stock exchange but cannot be used to raise capital. Level III ADRs are the most prestigious and allow an issuer to float a public offering of ADRs on a US exchange.

ADRs are just like stocks in that they trade on a stock exchange or over the counter, making them fairly easy to access and trade. They are also available through US brokers. However, investors may incur currency conversion fees when investing in ADRs.

One of the main benefits of investing in ADRs is that they provide investors with a way to diversify their portfolios. Investing in international securities allows investors to open their investment portfolios to greater rewards (along with the risks).

However, there are some drawbacks to investing in ADRs. One of the main problems is that they may involve double taxation—locally and abroad. There is also a limited selection of companies that offer ADRs.

Explore cash management accounts

A cash management account (CMA) is a non-bank cash account that combines the features of a checking account, savings account, and/or investment account. CMAs are typically offered by non-bank financial service providers, such as investment advisory firms or broker-dealers, and are usually managed online. They provide a simplified banking experience by allowing you to make transactions, earn high-yield interest, and sometimes use a credit line attached to your investment securities, all without having to transfer funds between different accounts.

• Interest Rates and Returns: CMAs often offer competitive interest rates that are higher than those of traditional bank accounts. However, it's important to shop around and compare different CMAs and online high-yield savings accounts to ensure you're getting the best rate.
• Federal Insurance: CMAs have different FDIC (Federal Deposit Insurance Corporation) and SIPC (Securities Investor Protection Corporation) coverage rules and limits depending on the financial institution. Some providers offer FDIC protection through their partnerships with program banks, while others may offer even higher protection limits. It's essential to understand the insurance coverage provided by your CMA provider.
• Account Features: CMAs typically offer features such as check-writing privileges, ATM access, debit cards, online payment services, and brokerage components. These features provide flexibility and convenience, allowing you to manage your finances in one place.
• Customer Service: One potential drawback of CMAs is the lack of face-to-face customer service. Like online banks, CMA providers tend to offer remote customer support to keep overhead costs low and pass the savings on to customers in the form of higher interest rates.
• Fees and Requirements: Some CMAs may charge monthly maintenance fees, require minimum balance maintenance, or impose fees for transferring funds or closing the account. It's important to carefully review the fee structure and requirements before opening a CMA.

Understand the impact of a strong dollar

A strong dollar can have a significant impact on emerging markets, and there are several ways to understand this. Firstly, a strong dollar can make it more challenging for emerging market economies to repay their dollar-denominated debts. As the dollar strengthens, these debts become more expensive to service, particularly when compared to their domestic currency. This challenge is further exacerbated when we consider that many emerging market economies cannot borrow in their own currency and are instead reliant on borrowing in dollars.

Secondly, a strong dollar can lead to capital outflows from emerging markets as investors seek the safety of US-denominated assets. This dynamic is often referred to as a "flight to safety". As investors exit positions in emerging markets, these economies experience a reduction in foreign investment and capital, which are crucial for their growth and development.

Additionally, a strong dollar can negatively impact the trade activities of emerging market economies. Many of these countries are price-takers in global markets and are heavily dependent on exports. When the dollar strengthens, their exports become relatively more expensive for foreign buyers, potentially reducing demand.

Moreover, a strong dollar can increase the cost of imports for emerging market economies. This can be particularly detrimental for firms operating in these countries, as they may be forced to reduce their investments or spend more on crucial imports.

Lastly, a strong dollar can have a dampening effect on the growth of emerging market economies. While these countries may raise their interest rates to remain competitive and attract foreign investment, higher interest rates also increase the cost of domestic borrowing and slow down economic growth.

Assess the pros and cons of emerging market bonds

Emerging market bonds are debt instruments issued by developing countries and corporations within those countries. They have become increasingly popular in investor portfolios in recent years due to their rising credit quality and higher yields compared to US corporate and Treasury bonds. However, it's important to assess the pros and cons before investing.

Pros:

• Portfolio diversity: Emerging market bonds provide portfolio diversity because their returns are not closely correlated to traditional asset classes.
• Currency risk hedge: Many investors choose to invest in emerging market bonds issued in local currencies to hedge against the currency risk in the rest of their portfolios.
• High yields: Yield returns of emerging market bonds have historically been higher than those of US Treasuries.
• Rapid growth: Developing countries tend to grow rapidly, which can enhance returns.
• Improved stability: Developing nations are becoming more stable, reducing the risk associated with investing in emerging markets.

Cons:

• Higher risk: Higher returns often come with increased risk. Emerging market bonds tend to carry higher risks than domestic debt instruments due to the potential political and economic volatility of developing nations.
• Default risk: All bonds carry the risk of default, but this risk is heightened in emerging market bonds due to the potential volatility of developing nations.
• Inflation risk: Inflation risk is a concern for all investment instruments, but it's a bigger reality for emerging market bonds because they generally have lower rates.
• Interest rate risk: Emerging market bonds are not immune to interest rate risk, and the degree of volatility increases as the bond nears its maturity.
• Currency risk: If a bond is issued in a local currency, changes in the exchange rate can positively or negatively impact your yield.

Frequently asked questions