Emerging markets have given investors something of a conundrum recently. Through much of the 2000s, emerging-market stocks trounced the returns of their developed-market peers. Yet more recently, the ascent of U.S. stock market indexes including the Dow Jones Industrials (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) has left emerging-market benchmarks in the dust. Specifically, the iShares MSCI Emerging Markets ETF (NYSEMKT:EEM) hasn't kept up with the overall market, and the exchange-traded fund still stands well below its record level reached in late 2007 before the financial crisis hit.
The iShares MSCI Emerging Markets ETF is one of the most popular choices among institutional and individual investors wanting exposure to emerging markets. Its expense ratio means shareholders pay 0.67% of their investment in the ETF annually, which is quite a bit higher than what the Vanguard FTSE Emerging Markets ETF (NYSEMKT:VWO) charges for similar emerging-market exposure. But regardless of which vehicle you pick, the success or failure of your emerging-market ETF depends on how China, Brazil, India, and other key emerging-market nations perform. We've discussed some of the factors supporting emerging markets in a past article, so let's turn to some reasons for concern that could send the iShares ETF downward.
1. Fed tightening could lead investors to exit emerging markets
Cheap-money policies in developed economies have created strong conditions for emerging markets in the past. During the emerging-market boom, investors were able to borrow in the U.S. and Japan at low interest rates and invest in higher-interest rate securities, especially in nations such as Brazil that sported extremely attractive rates. Combined with appreciation in foreign currencies against the dollar, that helped give emerging-market investors impressive gains.
Now, though, the U.S. dollar has strengthened in anticipation that the Federal Reserve will start raising interest rates within the next year. That jeopardizes what's known as the carry trade, as those borrowing U.S. dollars will face higher financing costs to maintain their loans. Trends toward a stronger dollar and a narrowing interest rate spread could well continue as the Fed begins its tightening phase; indeed, fears of tightening by the U.S. central bank helped prompt the underperformance of emerging markets in 2013. If investors start becoming risk-averse, they'll pull back on their aggressive emerging-market bets first, and that could send prices of the iShares ETF down more than the Dow and S&P.
2. Commodity-based economies like Brazil and Russia could see continued weakness in commodity prices
It's no accident or coincidence that emerging markets rose at the same time as many key commodity markets. Several important emerging markets, most notably Russia and Brazil, have a wealth of natural resources that helped drive the initial phase of their growth. During the commodity boom in the mid-2000s, those resources helped immensely in the development of their national economies.
Unfortunately, many important commodities have suffered big price declines in recent years, with copper, iron ore, and other base metals reflecting the sluggishness in expansionary efforts in infrastructure and construction. Many analysts hope these markets have finally hit bottom; if they have, then it could help pull emerging market stocks in those industries back upward. But the risk of further trouble in commodities is still very real, especially as the recession in Europe starts to look more alarming and poses a bigger threat to near-term demand. Sustained depression in commodity prices could hold back emerging markets and their recovery.
3. Political and economic instability is a constant threat in emerging markets
The recent geopolitical tension in Ukraine serves as a stark reminder that U.S. investors can't take the political stability they enjoy for granted in other parts of the world. Whether it's historically high levels of inflation in areas of Latin America, totalitarian politics in China, or the threat of economic sanctions against Russia, emerging-market investors face much different challenges than those who stick with developed economies.
If any of the economic or political factors that have complicated the international investing scene recently grow even larger, then emerging markets would likely find themselves the first to react. Without fully understanding the unique attributes of each country's own economic and political currents, investors leave themselves vulnerable to unanticipated problems that could hamper emerging-market-tracking ETFs.
Despite the potential of emerging markets, the iShares MSCI Emerging Markets ETF and other emerging-market investments involve substantial risks. Getting a handle on those exact risks is important to help you make the best-informed decision about investing in emerging markets.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.