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The Risks and Rewards of Emerging-Market Investing

David Francis

After a rough few years, U.S. stocks are finally staging a comeback. But this rally will have to be sustained for quite some time to compensate for the losses of the past few years.

The same can be said of markets in Europe and the rest of the industrialized world. Mature economies are still shaking off the dust collected during the Great Recession and trying to sustain momentum that could lead to a broader economic recovery.

[See What to Buy as the Dollar Rises.]

But this isn't the case for emerging economies, or the economies of nations that are experiencing quick industrialization and fast growth. The eight largest emerging economies are Brazil, China, Russia, Mexico, India, South Korea, Turkey, and Indonesia. Many other smaller countries in South America, Africa, and Asia are also experiencing periods of rapid expansion.

In recent years, many emerging markets have experienced double-digit growth. Stocks of companies based in these countries have performed equally well. For savvy investors, emerging economies provide a prime opportunity for large profits at a time when mature economies are producing small gains.

Identifying the next hot spot. The fast growth of the economies of China, Russia, Brazil, India, and other large emerging markets is well-known. Richard Linowes, an assistant professor in American University's Department of Management, says despite the rapid growth, there is still tremendous upside to investing in these countries.

"The oil sector in Russia continues to be attractive. It's boom time in India, serving the domestic market in China," he says. "Brazil has so much going on right now with the use of sugarcane in making ethanol and oil finds off of the coast."

Identifying the next hot market is more difficult and requires a higher level of international expertise. Linowes says the best to way to determine the next hot spot is to identify a growing need that is not being met, then find a country that can meet that need.

[See Why Latin American Stocks Could Get Hot.]

He cites the demand for rare earth metals as an example. As the name indicates, these metals are extremely hard to find, but are needed to manufacture a number of technological devices, including mobile phones and advanced weaponry. Therefore, countries with untapped rare-earth resources, including nations in Central Asia and Africa, are prime spots for growth.

Steep barriers to entry. The performance of emerging markets has been impressive in recent years, and is attractive to any investor looking for growth. But getting money into these markets is not an easy accomplishment, according to Frank Vogl, director of Vogl communications, a company that specializes in global finance and international economics.

"It's incredibly difficult for the ordinary individual to go and buy stocks in China," Vogl says.

Direct investment in emerging economies is easier for large, institutional investors, he says. For the average consumer, the best way to get into the emerging-market game is through mutual funds.

Many brokerage companies, including Franklin Templeton, Charles Schwab, and Fidelity offer funds that invest directly in emerging markets. He cites Mark Mobius, director of Franklin Templeton's emerging market funds, as especially capable in taking advantage of emerging-market opportunities.

Another option is to invest in multinational companies, or companies with a broad international presence. He cites Coca-Cola and Exxon as two examples.

"There are some people who would argue that an investor go to the most multinational of blue-chip companies," Vogl says. "You get diversification without the currency and political risk."

[See How to Play Emerging Markets With U.S. Stocks.]

Upside is high, but risks exist. Vogl says there are two primary threats to emerging-market investments. Foreign currency valuations are unpredictable and can swing rapidly. Many of these countries also have fragile political systems. This instability leads to uncertainty.

But as the performance of mature economies versus emerging economies has shown, the upside to investing in emerging markets is high. And according to the April 2012 Global Economic Monitor issued by the Institute of International Finance, opportunities are ripe across Africa.

"High yields on government securities in emerging and frontier markets in Sub-Saharan Africa have caught the eye of foreign investors over the past few years," the Institute found. "With returns in mature markets remaining low since the global recession in 2008, interest rate differentials have been large, making higher yielding, but inherently riskier, investments more attractive."

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