What are emerging market funds and should you be investing in them?

Emerging markets are economies that are progressing toward becoming advanced, developed economies. They typically have lower per capita income but offer higher growth potential. Emerging market funds allow investors to participate in the growth potential of these markets through a diversified portfolio of stocks, bonds and other assets.

In recent years, several mutual funds and ETFs focused specifically on emerging markets have become available in India. This has opened up a new asset class for Indian investors to consider beyond the traditional developed markets like the US and Europe.

Defining emerging markets

Emerging markets essentially refer to nations that are progressing from being low-income developing countries to upper middle or high-income developed countries. They are transitioning economies with rapid growth and development taking place.

While there are no standard criteria, markets with some key features like -

• Lower per capita income but rapid GDP growth

• Increased industrialisation and infrastructure buildup

• Rising literacy levels and standards of living

• Growing middle-class population

• Liberalisation of markets and foreign capital

• Larger share of agriculture and commodities

• are typically classified as emerging markets compared to mature advanced economies. MSCI classifies over 20 countries like Brazil, China, India, Korea, South Africa, UAE, etc., under its emerging markets indices.

Investment potential of emerging markets

• High GDP growth - Emerging nations have potential for higher growth compared to developed countries, which are already saturated.
• Demographic advantage - Emerging markets have younger populations, rising disposable incomes, and expanding middle class, which drives consumption.
• Underpenetrated markets - Sectors like banking, capital goods, infrastructure, and consumer products have lower penetration and higher growth runways in these economies.
• Diversification - Emerging market funds provide exposure to regions and sectors underrepresented in mainstream global funds dominated by developed market stocks.
• Relative valuations - Stocks and currencies of emerging markets are relatively undervalued compared to developed markets. This provides valuation cushion.
• Long-term wealth creation - Emerging markets have potential for higher returns over the long term that could aid portfolio growth.

Types of emerging market funds

• Diversified emerging market equity funds - These funds invest across stocks of companies located in multiple emerging market geographies and sectors.
• Regional emerging market funds - For example, funds focused specifically on Latin America, Asia, Eastern Europe, etc.
• Single country emerging market funds - For example, funds focused exclusively on equities of countries like China, Korea, Taiwan, etc.
• Emerging market bond funds - Funds focused on bonds, treasury bills, and other fixed-income instruments of emerging countries.

Risks and returns profile

Here is an overview of the typical risks and returns characteristics of emerging market funds for investors to consider:

Potential risks

• Political instability in some countries
  
• Commodity prices risks
  
• Currency fluctuation risks
  
• Liquidity risk and lower trading volumes
  
• Higher volatility compared to developed market funds
  
• Regulatory changes and governance issues
  

Potential returns

• Capitalise on high GDP growth rate
  
• Benefit from rising local consumption
  
• Gain from undervalued currencies and assets
  
• Exposure to sectors with higher growth potential
  
• Diversification to reduce overall portfolio volatility
  
• Potential for higher returns compared to mainstream funds
  

Assessing suitability for Indian investors

Here are some pointers for Indian investors to assess if including emerging market funds in their portfolio matches their risk profile and goals.

• Consider investing only 5-10% of the portfolio in emerging markets for diversification rather than large allocation.
  
• Have an investment horizon of at least 5-7 years to ride out the volatility en route to growth.
  
• Assess risk appetite, as emerging market funds have higher risk compared to domestic diversified equity funds.
  
• Be comfortable with currency fluctuations as funds are exposed to local currencies.
  
• Do not have any short-term liquidity needs from this corpus.
• Prefer funds with a long-term track record and performance history.
  
• Evaluate costs like expense ratios before investing.
  

Thus, adding emerging market funds in small to moderate quantities with a long-term view can potentially enhance overall portfolio returns for Indian investors willing to accept some additional volatility.

Conclusion

Emerging market funds offer investors exposure to high growth developing countries and provide diversification benefits. They provide access to younger demographics, underpenetrated sectors, and currencies outside the mainstream funds focused on developed nations. While historically they have demonstrated the ability to deliver higher returns over long periods compared to developed market funds, the additional volatility and risks need to be suitably factored in.