Sizing Emerging Markets for a Client Portfolio

There is no single correct share of a portfolio for emerging markets. Many advisers start from the market’s weight in a global stock index, roughly a tenth of world stock market value, and then adjust up or down for the client’s goals, time horizon and tolerance for volatility.

A younger client with a long horizon may hold that weight or slightly more. A retiree drawing income may hold much less, or none, because emerging markets can fall sharply and stay down for years.

The decision is an adviser’s judgment about one client, not a market forecast. For the full route from the exam to a career making these calls, our complete guide to how to become an investment adviser representative covers every step.

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What Makes a Market Emerging

Emerging markets are economies that are growing and industrializing but have not yet reached the income levels, market depth or investor protections of developed countries. Index providers classify each country using measures such as economic development, the size and liquidity of its stock market, and how easily foreign investors can move money in and out.

Index providers do not always agree. South Korea, for example, is classified as emerging by some providers and developed by others, which is why two emerging market funds tracking different indexes can hold noticeably different countries.

Below emerging markets sit frontier markets, which are smaller, less liquid and less accessible still. The Series 65 Exam Preparation course at FRC covers these classifications and the risks attached to each.

The Case For Holding Emerging Markets

The main argument for emerging markets is growth. Many of these economies have younger populations, rising incomes and expanding middle classes, which can support faster earnings growth than in mature economies over long periods.

The second argument is diversification. Emerging market returns do not move in perfect step with US stocks, so a modest allocation can smooth the path of a global portfolio over time, even if each year’s result is unpredictable.

The third argument is valuation. Emerging market stocks have often traded at lower price-to-earnings multiples than US stocks, which some investors see as compensation for the extra risk they carry.

The Risks the Exam Expects You to Know

Political risk is the possibility that a government changes the rules, through nationalization, capital controls, new taxes or sudden policy shifts. Currency risk is the chance that the local currency falls against the dollar, reducing the value of returns for a US investor.

Liquidity risk is higher because many emerging market stocks and bonds trade less often, so selling in a crisis can mean accepting a much lower price. Regulatory risk covers weaker accounting standards, less disclosure and fewer protections for minority shareholders.

These risks show up in higher volatility. Our comparison of standard deviation vs beta explains how advisers measure that volatility and compare it with a broad market benchmark.

Emerging Markets Compared With Developed Markets

How Currency Changes the Return

A US investor in an emerging market fund earns two returns at once: the change in local share prices and the change in the currency against the dollar. The two compound together, so a strong local market can be wiped out by a weak currency.

Worked example: an emerging market index rises 12 percent in local currency, but the local currency falls 8 percent against the dollar. Step one: multiply 1.12 by 0.92 to get 1.0304. Step two: subtract 1, so the return to the US investor is about 3.04 percent, far below the 12 percent the local headline suggests.

The effect works in reverse too. If the local currency strengthens, a US investor earns more than the local return, which is why some funds hedge the currency and others leave it open, as our comparison of hedging vs speculation explains.

Study International Investing With FRC

International investing questions on the exam usually test the risks of foreign securities, the role of American depositary receipts and how currency movements affect returns. Our Series 65 course explains each with examples linked to client recommendations.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Sizing the Allocation Step by Step

Advisers usually decide the overall stock allocation first, then decide how much of that stock allocation goes overseas, and only then how much of the overseas share goes to emerging markets. Working in layers keeps each decision tied to the client’s plan.

Worked example: a client has a $400,000 portfolio with 70 percent in stocks. Step one: the stock allocation is $280,000. Step two: the adviser places 12 percent of the stock allocation in emerging markets, which is $33,600, or 8.4 percent of the whole portfolio.

The same client with a shorter horizon might hold 50 percent in stocks and 6 percent of that in emerging markets. That reduces the emerging market position to $12,000, or 3 percent of the portfolio.

What a Modest Allocation Does to Return and Risk

Adding a small emerging market position rarely transforms a portfolio’s return, but it changes the mix of risks. The combined effect depends on expected returns, volatility and how closely the markets move together.

Worked example: a portfolio holds 90 percent US stocks expected to return 8 percent and 10 percent emerging market stocks expected to return 11 percent. Step one: multiply 0.90 by 8 to get 7.2, and 0.10 by 11 to get 1.1. Step two: add them for an expected return of 8.3 percent, an increase of 0.3 percentage points.

Now consider risk. With 85 percent in US stocks with a standard deviation of 15 percent, 15 percent in emerging markets with a standard deviation of 22 percent and a correlation of 0.75, the portfolio standard deviation works out to about 15.4 percent, below the 16.05 percent weighted average of the two, because the markets do not move perfectly together.

Ways to Invest in Emerging Markets

Most US investors reach emerging markets through mutual funds or exchange-traded funds that hold hundreds of companies across many countries. Broad funds spread the political and company risk that comes with any single country.

American depositary receipts allow investors to buy shares of individual foreign companies on US exchanges, priced in dollars. An ADR is still exposed to currency risk, because the value of the underlying shares is set in the local currency.

Emerging market bonds come in two main forms: bonds issued in dollars, which remove direct currency risk for US investors, and bonds issued in local currency, which add it. Many emerging market governments carry ratings below investment grade, a distinction covered in our comparison of investment grade vs high yield bonds.

Concentration Inside Emerging Market Funds

A broad emerging market fund is not spread evenly across dozens of countries. Because funds weight countries by stock market value, a handful of the largest markets in Asia usually make up a large share of the fund, and a few big technology and financial companies can dominate its returns.

This matters when a client believes they own a balanced slice of the developing world. A single country’s policy change, or a fall in one large company, can move the whole fund more than the client expects.

Advisers read a fund’s country and sector breakdown before recommending it. Some clients prefer funds that cap any one country’s weight, or that exclude a particular country, which changes both the risk and the return profile.

Index Funds or Active Management

Emerging markets are often described as less efficient than developed markets, because information spreads more slowly and fewer analysts follow each company. Supporters of active management argue this gives skilled managers more room to add value.

The counterpoint is cost. Active emerging market funds usually charge higher fees than index funds, and trading in less liquid markets adds further expense, so a manager must outperform by enough to cover both before the client benefits.

Many advisers use a low-cost index fund as the main emerging market holding and add an active fund only where they have a clear reason. Whichever route is chosen, the adviser explains the fees and the reasoning to the client and records them in the file.

Tax Points on Foreign Investments

Many foreign countries withhold tax on dividends paid to US investors before the money arrives. Worked example: a $1,000 dividend with 15 percent foreign withholding leaves $850; in a taxable account the investor may be able to claim a foreign tax credit for the $150.

In a tax-deferred account, such as an IRA, the foreign tax credit is generally not available, so the withheld tax is simply lost. This is one reason some advisers hold international funds in taxable accounts where it suits the client.

Funds report foreign taxes paid on year-end tax forms, and the rules on claiming the credit can be complex. Advisers coordinate with the client’s tax professional rather than giving tax advice outside their expertise.

Matching the Allocation to the Client

Suitability comes first. A client who would sell after a 30 percent fall should not hold an emerging market position large enough to cause that reaction, however attractive the long-term growth case appears.

Time horizon matters because emerging markets have had long stretches of poor returns. A client who needs the money within a few years may have no time to recover from a deep decline.

The client’s existing holdings matter as well. Someone who already owns large US companies with substantial overseas sales has some indirect emerging market exposure, which an adviser can take into account when sizing a direct position.

Rebalancing and Keeping Discipline

Emerging market positions can drift quickly because their returns swing more widely. After a strong year, a 10 percent target can grow to 14 percent, and after a bad year it can shrink to 6 percent.

Rebalancing on a schedule, or when a position moves beyond set limits, keeps the risk level where the client agreed it should be. It also means trimming after gains and adding after losses, which runs against most investors’ instincts.

Advisers document the target, the limits and the reasoning in the client file. If markets fall and the client asks why the adviser is buying more, the written plan explains the decision.

The Memory Aid

Remember “GCV for the case, PCLR for the risks”: growth, correlation and valuation support emerging markets; political, currency, liquidity and regulatory risks are the costs.

For currency, remember “multiply, don’t add”: a 12 percent local gain and an 8 percent currency loss give about 3 percent, not 4 percent.

For ADRs, remember “dollar price, local value”: an ADR trades in dollars but still carries the currency risk of the underlying shares.

Exam Traps to Avoid

The first trap is assuming an ADR removes currency risk. It removes the need to trade in a foreign currency, but the value of the underlying shares still moves with the local currency.

The second trap is confusing emerging markets with frontier markets. Frontier markets are smaller, less liquid and less developed than emerging markets.

The third trap is treating emerging markets as suitable for every client. A large position may be unsuitable for a client with a short horizon or low tolerance for volatility. The fourth trap is forgetting political risk, which applies to foreign investments and is a frequent exam answer when a question mentions nationalization or capital controls.

A Client Scenario

A 35-year-old client reads that emerging markets have grown faster than the US economy and asks the adviser to put half of her portfolio into an emerging market fund. Her goal is retirement in 30 years, but she admits she was uncomfortable during the last market fall.

The adviser explains the growth case, but also the political, currency and liquidity risks, and shows how a 50 percent position could fall far further than she has experienced. They agree that a position of around 10 percent of her stock allocation fits her horizon and comfort level better.

The adviser sets a rebalancing range, explains that the position will be adjusted if it drifts outside it, and records the discussion and her agreement in the client file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the emerging markets entry to see classification, risks and returns explained on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: An emerging market index rises 10 percent in local currency while the currency falls 5 percent against the dollar. What is the approximate return to a US investor? 1.10 times 0.95 is 1.045, so about 4.5 percent.

Question two: Does buying an ADR eliminate currency risk? No; the value of the underlying shares still moves with the local currency.

Question three: Which risk describes a foreign government seizing private companies? Political risk.

Question four: A client has $500,000 with 60 percent in stocks and puts 10 percent of the stock allocation in emerging markets. How much is in emerging markets? $30,000, or 6 percent of the portfolio.

Question five: Which are smaller and less liquid, emerging markets or frontier markets? Frontier markets.

Turn Global Knowledge Into Career Evidence

Clients increasingly ask about investing beyond the US, and an adviser who can explain both the opportunity and the risks clearly earns lasting trust. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining how a currency fall can erase a strong local return shows the international understanding advisory firms look for.

Related Questions

Country and political risks inside emerging markets are partly diversifiable, while global market swings are not, as our comparison of systematic vs unsystematic risk explains. To judge whether an emerging market fund’s extra return makes up for its extra volatility, see Sharpe ratio vs Treynor ratio.

Key Points to Retain

There is no fixed correct allocation to emerging markets; advisers often start near the market’s share of global stocks and adjust for the client’s horizon, goals and tolerance for volatility. The case rests on growth, diversification and valuation, while the costs are political, currency, liquidity and regulatory risks.

Currency and local returns compound together, ADRs still carry currency risk, and frontier markets are riskier again. Advisers size the position in layers, rebalance within set limits and document the reasoning for each client.

For the role the exam leads to, read our guide to what an investment advisor representative is.