Emerging markets now generate more than half of the world’s gross domestic product. Yet investing in these markets comes with substantial risks, even though they’ve created a nearly $4 trillion sub-asset class in a variety of sectors.
These markets present attractive opportunities, but investors face several challenges. Currency swings, political unrest, and limited liquidity can seriously affect your investment returns. Your carefully planned investments might suffer from political events like wars, tax hikes, and policy shifts. Currency changes also play a crucial role since profits come in local currencies that need conversion to your home currency.
The challenges don’t stop there. Poor corporate governance raises the chances of bankruptcy because management often has more control than shareholders. These markets also tend to be less liquid than developed economies. This leads to higher broker fees and makes it harder to determine fair prices. The good news? Data reveals that investments bounce back strong after defaults, with recovery rates averaging 72%—better than many other investment types.
This piece takes a closer look at the hidden risks of emerging market investments. You’ll learn expert ways to manage these risks and make smarter choices for your portfolio.
Currency Volatility and Exchange Rate Exposure
Currency fluctuations are one of the most overlooked risks that can affect your investments in emerging markets. Buying foreign assets means you’re making two investments at once: one in the asset itself and another in its currency.
Impact of Local Currency Depreciation on USD Returns
The math behind currency’s effect is simple but might surprise you. Here’s a real-life example: The MSCI European Union Index showed an impressive 11.18% return in local currency terms in early 2025. U.S.-based investors saw only 6.39% after dollar conversion – the dollar’s 6.4% gain against the euro wiped out almost half the original returns.
This currency effect isn’t small – it makes up most of the volatility in emerging market returns. Currency movements in the last decade created a big gap between local currency returns of non-U.S. stocks and their USD performance. Your investment value drops even if the assets do well when emerging market currencies lose value against the dollar.
The dollar’s weakness can boost your returns too. Your USD returns can be bigger than local currency performance when the dollar falls against emerging market currencies. Investment experts call this a “dual return stream” – you get returns from both stocks in local currencies and exchange rate changes.
Hedging Strategies for FX Risk in Emerging Markets
Managing currency risk in emerging markets brings unique challenges compared to developed economies. Emerging market currencies face more volatility from political changes, commodity prices, and money flows. Hedging tools for these currencies are limited and cost more than those for major currency pairs.
You can reduce these risks through:
- Forward Contracts: These tools let you lock in exchange rates for future deals. They give certainty but can cost too much in high-interest emerging markets due to rate differences.
- Currency Options: Options give you the choice, not obligation, to exchange at a specific rate. They cost less than forwards when interest rates differ widely.
- Natural Hedging: You can match your money coming in and going out in the same currency or broaden investments across different emerging markets.
- Selective Hedging: Targeting specific risks based on economic conditions works better than hedging everything. Chinese markets now offer good hedging opportunities because of interest rate differences with the U.S..
- Relative Value Strategies: This method uses price gaps between currency pairs to lower volatility while keeping exposure to stronger markets.
Your investment timeline and risk comfort level determine the best strategy. Complete hedging might not work for long-term investors since hedging costs can be higher than currency risk costs.
Liquidity Constraints in Thinly Traded Markets
The basic structure of many emerging markets shows thin trading environments. Finding willing counterparties becomes a big challenge. These markets have varying levels of liquidity – knowing how to turn assets into cash quickly without moving the price creates hidden risks that investors often miss until too late.
Challenges in Exiting Positions During Market Stress
Getting out of positions during market downturns in emerging markets tests both timing and patience. Developed markets usually attract buyers during selloffs. However, emerging markets often face one-way selling pressure. This mismatch between buyers and sellers hits institutional investors hard.
To name just one example, see thinly traded securities where you might find only two or three potential counterparties who could take the other side of your trade. Then, as market sentiment turns sour, these few participants vanish. Finding willing buyers takes extensive effort with little reward.
A troubling pattern emerges when institutional investors try to exit positions – they make up over 70% of daily trading volume in many markets. These big traders split their orders into smaller blocks over time. More than half of institutional trades take at least four days to complete. Rushing this process during market stress only makes price drops worse.
Higher Transaction Costs and Broker Spreads
Thin markets punish traders twice through direct and indirect costs. Lower trading volumes in emerging markets lead to higher transaction costs. Wider bid-ask spreads show this clearly – that’s the gap between what buyers offer and sellers want.
Central and Eastern European markets have bid-ask spreads of 5.61% – almost triple the 1.96% seen in developed markets. Small-cap equities in emerging markets tell an even starker story. Their spreads once reached 100 basis points but have improved to around 37 basis points lately.
Rules and regulations add to transaction costs through taxes and fees. Markets in Chinese Taipei, Romania, Malaysia, and Poland found that cutting transaction taxes boosted market liquidity. Markets without capital gains taxes tend to see more trading.
Case Study: Illiquidity in Frontier Market Real Estate
Frontier market real estate shows the worst of illiquidity risks. Real estate makes up about 30% of total net wealth in the US and 21% in the UK. This makes it a huge part of many investment portfolios. In spite of that, navigating illiquid frontier real estate markets remains tough.
A newer study of UK non-listed real estate funds revealed an illiquidity premium of 84 basis points yearly. Investors wanted almost a full percentage point of extra return to make up for illiquidity risks. This premium exists because selling these investments during market stress becomes extremely difficult.
Market downturns show illiquidity at its worst, especially in frontier markets with weak institutional frameworks. The 1997-98 Asian financial crisis left most affected economies with a severe liquidity crunch that questioned their financial systems’ basic operation. The property market froze completely – barely any deals could happen at any price.
Smart investors know these liquidity limits help them size positions correctly and set realistic exit goals in emerging markets.
Political Instability and Regulatory Uncertainty
Political risk affects emerging market returns much more than developed markets. Countries with lower political risk outperform those with higher risk by about 11% quarterly in emerging economies. This difference drops to just 2.5% in developed markets. These numbers show why investors should understand the political scene before putting money into these regions.
Election Cycles and Policy Reversals
Elections in emerging markets create a lot of uncertainty about finances. Government spending goes up by 0.5 percentage points of GDP during election years. Wage bills also rise by 0.1 percentage points, which pushes fiscal deficits up by 0.6 percentage points. These financial problems don’t go away after elections. They create a snowball effect that puts long-term public finances at risk.
These patterns show up in both democratic and non-democratic systems. Economic uncertainty lies at the heart of this issue. Research shows that higher uncertainty makes companies hire less and invest less. People also spend less money, which hurts the overall economy. Investors face more market swings around election time, no matter what political system runs the country.
Nationalization and Expropriation Risks
The risk of government takeovers has grown lately. This comes from resource nationalism, the need for energy transition, and populist movements worldwide. Resource-rich countries often push out foreign investors or change laws to get more money for the state.
Latin America shows this trend clearly. The Mexican government stopped oil auctions and gave major oil discoveries to state-owned Pemex. They also canceled fuel import permits from competitors. Chile wants to start a state lithium company and charge more for mining. Peru’s government aims to keep 70% of profits made within its borders.
Legal System Limitations in Contract Enforcement
Most emerging markets struggle with contract enforcement because they lack strong, independent courts. Political pressure often drives decisions, and corruption runs deep in many areas. Local officials and judges tend to favor domestic companies when disputes arise with foreign investors.
Written laws often differ from how they work in practice. Officials who don’t really understand market economics might misuse laws that give judges too much freedom. Courts can’t always enforce decisions due to limited resources or political priorities. China serves as a good example, where laws on paper don’t match reality.
Western companies prefer arbitration over local courts. But arbitration has its own problems. Restrictions on foreign lawyers and trouble enforcing decisions make things harder, especially when dealing with government entities.
Corporate Governance and Transparency Gaps
Corporate governance standards show huge differences in emerging markets. These differences create major investment risks that often stay hidden until a crisis hits. Research shows that all but one of these low-income developing countries either never posted debt data on their websites or haven’t updated it in over two years.
Insider Trading and Market Manipulation Risks
Market manipulation schemes flourish when regulatory oversight is limited. These schemes spread across multiple platforms and disrupt entire economies. Scammers often use pump-and-dump schemes to artificially drive up stock prices before selling their shares. The DoJ and SEC recently charged several people in a $100 million securities fraud case. The fraudsters used social media influencers to promote various stocks. This becomes an even bigger issue in emerging economies that have fewer anti-manipulation rules than developed markets.
Weak Audit Standards and Financial Reporting
Audit quality in emerging markets faces deep structural problems. The financial reporting process has built-in conflicts of interest that make it hard to trust. Independent auditors should provide reliable assurance. Their effectiveness takes a hit because the companies they audit hire and pay them. Countries with weak institutions can’t protect their oversight authorities from poor governance and corruption. The information gaps create major differences – some emerging markets’ debt data shows variations up to 30% of their GDP across different sources.
Board Independence and Shareholder Rights
Board structures in emerging markets reveal troubling trends. The MSCI Emerging Markets index shows 53% of companies have boards with independent majorities, but questions remain about the Board Chair’s independence. These companies mostly have controlling shareholders – about 70% compared to just 18% in the MSCI US index. Small investors face risks because only 13% of emerging market companies hold regular Say-on-Pay votes at shareholder meetings. This number jumps to 97% in Europe and 92% in the US. Only 4% of these companies prove they use long-term sustainability metrics to evaluate management performance.
Bankruptcy Risk and Capital Access Limitations
A fundamental paradox exists in emerging markets investment: economies with the fastest growth face the highest borrowing costs. This creates unique bankruptcy risks you won’t find in developed markets. The way companies access capital deeply shapes how investments perform in these regions.
High Cost of Capital and WACC in Emerging Economies
The weighted average cost of capital (WACC) shows a clear financial divide between emerging and developed economies. Power sector companies in African countries deal with an average WACC of 15.6%. This is a big deal as it means that it’s much higher than the 5.1% in the USA, 4.2% in Western Europe, and 2.4% in Japan. These markets pay more despite their stronger growth potential.
Developing countries pay triple the interest costs compared to developed nations. Developed countries borrowed at about 1% over the last decade. Meanwhile, least developed countries (LDCs) paid over 5%, with some rates going above 8%. These high costs hurt their financial health – LDCs spend 14% of their domestic revenue on interest payments, while developed countries spend just 3.5%.
Limited Access to Long-Term Debt Instruments
High costs aren’t the only problem – emerging market businesses struggle to get the right type of financing. The International Finance Corporation found a $5.2 trillion yearly financing gap for formal micro, small, and medium enterprises in developing countries. This especially hurts their ability to make long-term investments needed for sustainable growth.
Higher WACC limits business development because fewer projects can generate positive net present value as capital costs rise. The financial systems in emerging markets stop companies from taking on profitable projects that would be possible in developed economies.
Default Probability in Weak Legal Environments
The quality of institutions plays a huge role in default risk. Advanced economies have a 7% default probability on sovereign external debt, while developing economies face 17% – jumping to 34% for Latin American countries. Countries with strong institutions see way fewer sovereign defaults, shown by a -0.53 correlation between institutional quality and default probability.
Weak corporate governance makes bankruptcy risk even worse. Poor auditing lets companies hide their true profitability until sudden drops in value occur. Governments with weak institutions can’t coordinate policies that help different economic sectors, which leads to more defaults overall.
These structural financing challenges help investors fine-tune their risk expectations when putting money into emerging markets. The higher returns must make up for these built-in risks.
Conclusion
Final Thoughts on Navigating Emerging Market Risks
Emerging markets offer great growth potential without doubt. Your success depends on knowing how to understand and alleviate the complex risks outlined in this piece. Currency volatility can erode returns up to 50%. Liquidity constraints might trap your capital during market stress. This reality changes how we assess risks completely.
Political instability creates a crucial challenge. Countries with lower political risk perform better than their counterparts by about 11% quarterly. These numbers deserve your attention when building your portfolio. Weak corporate governance standards and limited financial transparency create an investment world that needs specialized knowledge and careful planning.
Bankruptcy risk needs your attention. Capital costs run three times higher than in developed markets. This limits growth potential for promising ventures. Higher returns become necessary for emerging market investments to make up for these built-in challenges.
Emerging markets still provide value in diversified portfolios with proper risk controls. Your strategy should include currency hedging tools, full political analysis, and careful liquidity management. This protects against downside scenarios while you retain control of growth opportunities.
Smart investors know emerging market allocation needs more than passive index tracking. A custom approach based on your risk tolerance, time horizon, and financial goals creates the best foundation to navigate these complex markets. Investment professionals who focus on emerging markets can boost your portfolio results and help turn these challenges into opportunities.
High-net-worth investors and family offices get better results from custom emerging market strategies that line up with their wealth management goals. These investments might underperform without proper guidance. Expert management can deliver both portfolio diversification and better returns.
Schedule a strategy call before making big emerging market moves. This helps assess how these investments fit your complete financial plan. Your capital works efficiently while keeping appropriate risk levels. This balanced approach recognizes both the big opportunities and unique challenges these markets offer.
