There are essentially two broad categories of investors—retail and institutional. Institutional investors are the big fish of the investment world. They wield hundreds of millions or billions of dollars and generally have a dedicated research staff and even trading desk to implement their portfolios. Their clients are huge foundations, endowments, and pension plans.

Retail investors, on the other hand, are the minnows of the investing universe. They have portfolios in the thousands of dollars up to a few million. They generally access their accounts online, place trades electronically or over the phone with a broker, and generally conduct their own research. Or they may hire a professional—usually one who specializes in working with other retail investors.

Most people are retail investors. But don't let that make you feel inferior—minnows can still swim. Twenty years ago, investing in emerging markets was a cumbersome affair. Access to local markets was difficult and only institutions with custodial and trading contacts across the globe could efficiently invest. A lack of data other than broad index information also hindered proper due diligence and reporting. Retail investors were at an even greater disadvantage. For them, hiring a professional money manager was virtually the only option for emerging markets exposure.

Many of these barriers have crumbled. Professional money managers still provide worthwhile services for those without the time or confidence to do it themselves, but a range of new instruments, like American Depositary Receipts (ADRs) and exchange-traded funds (ETFs), offer alternatives. Today, retail investors can easily construct a wide variety of strategies on their own. The chasm between the capabilities of an institutional and retail investor has narrowed considerably.

For either type of investor, there are two broad investment strategies— passive or active. At the broadest level, an active approach tries to outperform a benchmark by intentionally deviating from it. If you have a particularly positive outlook for a specific country or sector, for example, you may overweight it relative to the benchmark, and vice versa. Conversely, you can underweight areas you have less positive outlooks for. (Recall Chapter 6 for a refresher.)

A passive approach, on the other hand, tries to make a portfolio mirror the respective benchmark as much as possible. For instance, a passive emerging markets investor would allocate 8.4 percent to South African stocks, 5.2 percent to Mexico, and 18.2 percent to China (see Table 5.1 for these weights). He'd also invest 22.8 percent of his portfolio to Financials stocks and 7.7 percent to Industrials (see Table 5.2). A passive approach thus neutral weights all categories of stocks relative to the benchmark.

The instruments used will depend on your approach. A passive approach frequently means eschewing individual stocks for instruments with broader market exposure like mutual funds or ETFs. (An ETF is a passive investment that mimics the performance of a specific benchmark; more on this in a bit.) But this doesn't necessarily mean a passive approach requires no work—investors must carefully monitor exposure and rebalance periodically.

An active approach utilizes a broader range of instruments. Individual stocks usually play a predominate role. But investors may also use passive investments to create an active strategy. How so? Imagine an investor builds an all-ETF portfolio. Is it a passive strategy if a portfolio is made up entirely of passive investments? Not necessarily. In our example, rather than own ETFs precisely to the weight in the benchmark, such as 5.2 percent allocation to Mexico's ETF (EWW), an investor could hold more or less depending on his view of the country. If you were particularly bullish on Mexico, you could allocate 10 percent of your portfolio to EWW, a notable overweight to the benchmark. This is an active allocation (country bet) using a passive investment.

Many tools used today are common across all categories. But each case—institutional versus retail and passive versus active—calls for slightly different considerations. Next, we more closely evaluate the instruments at emerging markets investors' disposal.

We discussed the basics of security selection in Chapter 7. If you've decided to dive full bore into emerging markets and pick your own stocks, there are two distinct types of shares at your disposal—ordinary shares or depositary receipts.

Exchange-traded funds also represent an important tool to both retail and institutional investors. ETFs share many of the same attributes as index funds—namely lower costs and efficient diversification (more on index funds in a bit). But there is one major difference. While mutual funds are priced only once a day (at the market's close), ETFs trade intraday like a stock. This subjects them to different standards. ETFs must report holdings daily, giving them greater transparency.

ETFs allow investors to make fairly precise investment decisions while reducing stock-specific risk. This can be especially useful for emerging markets. For example, Thailand accounts for 1.4 percent of the MSCI Emerging Markets Index (see Table 5.1). Since it's a relatively small portion of the index, a bullish investor might only buy a stock or two to overweight the country. But that leaves the investor exposed to stock-specific risk. Instead, he could buy the iShares MSCI Thailand (THD), an ETF tracking the broad Thai market, and effectively eliminate this risk.

There is a dizzying array of ETFs available to emerging market investors. Table 8.1 lists those from two well-known ETF providers—Barclays (iShares) and State Street Global Advisors (SPDRs). Other providers offer more, but no matter which one you choose, there are funds for all types of investors and strategies. For example, investors desiring simple, broad exposure can purchase a fund like the iShares MSCI All-Country World Index (ACWI), an index tracking performance of all developed and emerging markets. Others after more active management can utilize individual country and regional funds. For example, maybe you've done more analysis on Latin America and think you have a pretty good idea about how things work in that part of the world. But you don't know much about Eastern Europe or Asia and don't believe you have any particularly valuable insight into stocks there. You could purchase a fund for these regions (GMF and GUR) and then pick individual stocks for Latin America. Such permutations are endless.

Mutual funds are primarily a tool used by retail investors to gain access to a professional money manager. These services remain popular, and there are good reasons for this. Mutual funds are a one-stop shop—purchasing a fund gives an investor access to a team of analysts and trading and custodial contacts—taking the onus off the retail investor. They also benefit investors with smaller accounts because they offer diversification—an especially important consideration for volatile emerging markets—in one neatly packaged security.

But there are negatives. Mutual funds offer no customization. They're commingled assets, meaning investors' money is pooled together and managed as one large portfolio. Each investor gets the same stocks and allocation decisions as every other investor. This also means they are not tax efficient—investors don't get the benefit of realizing losses to offset gains at tax time. Mutual funds are also not particularly transparent. They are only required to report holdings once a quarter and often only divulge a detail or two about the manager.

Any big mutual fund company (e.g., Fidelity, Vanguard, Legg Mason) likely offers an emerging market fund. But before committing to one, investors should studiously evaluate candidates on several key points.

Liquidity refers generally to both the cost and ease of transacting in a particular security. A liquid market implies ready and willing buyers and sellers at all times and a high probability that the next executed trade is at a price equal or close to the last one. Such factors vary tremendously across stocks—some exchange hands many millions times each day, while others only trade a few times over the course of several weeks.

In general, emerging market stocks tend to trade less, making liquidity considerations particularly important. Table 8.4 shows the average daily trading volume across several developed and emerging markets. Most emerging market countries trade substantially less than their developed market peers. China, the most actively traded emerging market, still only has a third of the volume traded in the US. At the other end of the spectrum, Peru only trades $29 million a day.

Why does liquidity matter? Imagine you're the manager of a $1 billion portfolio with 100 stocks. To simplify, let's say each position is the same weight—1 percent of the portfolio, or $10 million. That may seem like quite a bit of money in one stock, but for big, developed market stocks, it's often a drop in the bucket. For example, as of this writing, shares of General Electric (GE), the US industrial giant, traded on average 116 million shares a day at roughly $21 a share.^[194] That means well over $2 billion in GE shares exchanged hands each day. A $10 million trade would hardly make a dent in the stock's daily volume.

Now imagine you're trying to purchase $10 million in Bank Pekao, a sizeable Polish bank ($11 billion market capitalization). The stock traded 571,000 shares a day at an average of $56 per share, equating to a little over $30 million in dollar volume.^[195] Here, a $10 million trade would account for a substantial amount of one day's total volume. Since purchasing one-third of a stocks' daily volume at once would likely move the market price (sellers would match the sudden increase in demand with an increase in price), investors could spread the purchase out over the course of several days. But that also means it would take several days to sell out of the security later—the lack of liquidity compromises flexibility and quick action.

Liquidity also matters because it affects transaction costs. With financial instruments (stocks, ETFs, currencies, etc.), the price one investor pays is usually more than another investor collects. The different prices are known as the bid and the ask, and the bid-ask spread varies depending on the supply and demand of the security. If a stock has relatively few shares trading (i.e., it's less liquid) the buyer will command a premium as compensation, resulting in a higher bid-ask spread. In our example, this cost is likely negligible for GE but might cause an investor to think twice about Bank Pekao.

Liquidity concerns aren't just a concern for institutional investors wielding large sums of money. Smaller retail investors will also face difficulties buying ordinary shares in smaller markets. Trading volumes for ADRs can be problematic as well—many Level I ADRs barely trade at all. In either case, a liquidity analysis should be conducted by all investors prior to trading any security.

If you're an institutional investor, it's relatively straightforward to gain access to most developed market stock exchanges. Fill out a few forms, pay a nominal fee, establish custodial accounts, and you're up and trading—for the most part. Local trading access is usually prohibitively expensive for individual retail investors, but they can easily leverage their broker's institutional contacts.

Similar access to emerging market exchanges, however, can be particularly onerous. Hefty fees, long waiting periods, strange and inconvenient requirements, shallow depositary markets, and many other impediments can make even the sanest investor question whether it's worth it.

Take investing in India. There are essentially two ways to invest in Indian shares: Register as a Foreign Institutional Investor (FII) to trade on India's domestic stock exchanges or buy depositary receipts. There are notable difficulties and expenses associated with both options.

To register as an FII, investors must submit an application with the Securities and Exchange Board of India (SEBI). The investor must pay a $10,000 registration fee every three years, and any sub-accounts managed by the investor—a common structure for institutional investors—must also register with the SEBI and pay a $2,000 registration fee.^[196]

On top of the steep fees, the government limits the amount of shares FIIs can purchase. Individually, no one FII can own more than 10 percent of a company's outstanding shares. Sub-accounts can hold no more than 5 percent. And as a group, FII investment is capped at 24 percent.^[197] All these restrictions mean the Indian ordinary market is relatively shallow. Less than 100 Indian stocks, out of more than 3,000 listed, make up roughly 75 percent of shares traded.^[198]

With such a cumbersome and challenging road to investing in Indian ordinary shares, one might think the ADR universe would provide a suitable alternative. Not quite. Only 25 companies list ADRs and only 14 of those, listed in Table 8.5, trade with any volume on a US exchange. There simply aren't many options available to US investors—market accessibility is low.

Other markets pose different challenges. To trade Argentine ordinary shares, an account must be open with the central bank for a full year beforehand. Opening a custody account in Turkey costs several thousand dollars. Many similar hurdles exist in other nations. Fortunately, the trend is toward greater market accessibility as governments increasingly recognize the benefits of open capital markets. But investors must evaluate these types of costs in each market before determining if an investment in individual stocks is appropriate.

Developed market stock exchanges are reliably open for business—rarely do they close without warning. The same is not always true for emerging markets, where greater degrees of political, social, and economic volatility means markets often shutter unexpectedly, sometimes for extended periods. In late 2008, for example, Russian officials closed the local exchange on four separate occasions due to worries that intense selling pressure on the ruble and stock market threatened stability.^[199] Clearly, such unpredictable action increases the risks associated with investing in ordinary shares—another reason owning depositary receipts may be preferable since they're not traded on local exchanges.

Repatriating investments in emerging markets can also be potentially problematic. Most investors don't think twice about buying stocks in Canada or France—strong property rights in developed markets reassure investors will be able to send home the proceeds from their assets when the time comes to sell. The same cannot be said for some emerging markets, where property rights are notably weaker. While not common, there have been several historical instances where countries restricted the free flow of foreign investor capital.

For example, in the wake of the Asian Financial Crisis, trading in Malaysian ringgit instruments was banned as the government tried to stabilize markets. Officials then instituted a 12-month holding period on the repatriation of securities by foreign investors. That is, investors were unable to retrieve their money out of the country for a full year.^[200] The government loosened restrictions several months later, but investors were still subject to hefty levies, up to 30 percent, if they withdrew money earlier than the 12-month period.^[201] Thailand's government instituted similar capital controls following its 2006 coup d'état.