What Are Emerging Market Funds and How Do They Work?

Many investors in stock and bond markets use funds as the easiest way to create a portfolio, rather than trying to create it themselves by picking individual securities. Mutual funds and index funds are popular in the United States and other leading financial markets, and they are increasingly being used to invest in emerging markets as well.

What is an emerging market fund and how does it work?

An emerging market fund invests in a variety of securities originating in countries considered to be emerging markets. These nations aspire to become developed markets such as the U.S., western Europe, Canada, Japan, Australia, and New Zealand.

Emerging market economies generally grow faster than developed markets. Their governments promote reforms and financial regulations akin to those in developed countries. For U.S. and other foreign investors, although there is the potential for greater returns than in their home markets, there also is the risk of greater volatility.

An emerging market fund usually will be structured to indicate the size of the investments in each country. This structure, known as weighting, is often based on factors such as the size of a country's gross domestic product and its international trade balance. China, because its economy and stock market is so large, typically has the biggest weighting in most emerging market funds.

In addition, a fund’s weighting of asset classes such as stocks and bonds will be determined by the size of a country’s stock and bond markets, as well as by the industries and sectors in those markets. For example, the technology sector is very large in China, Taiwan, Singapore, and South Korea, so Asian tech stocks will usually have a large representation in emerging market funds.

The best-known group of emerging markets—known by the acronym BRIC for Brazil, Russia, India, and China—typically has a dominant weighting in the securities selected for emerging market stock and bond funds. They also dominate the market indexes used to create index funds. China, for example, accounts for about a third of the MSCI Emerging Markets Index, which is the most-used benchmark for emerging-market stocks.

Types of emerging market funds

Emerging market funds usually are characterized by asset class along the following breakdown:

Equity

These focus on stocks. An equity fund may represent the full array of emerging market countries and industries, typically through an index, or it may focus on a particular country or region—a Latin America fund, or an Asia-excluding-China fund, or an Asian technology fund, for example.

Index funds give investors broader exposure to emerging market stocks by including shares of hundreds or thousands of companies. The MSCI Emerging Markets Index includes more than 1,400 large-cap and mid-cap stocks from 24 countries, while the Dow Jones Emerging Markets Index has more than 3,900 stocks including small-caps. Indexes usually are dominated by stocks from China, India,​​ Taiwan, and South Korea, sometimes accounting for more than 50% of the index’s composition.

Actively managed equity funds tend to hold fewer companies as managers select specific investments in an effort to outperform the indexes by making bigger bets on potential winners. Their returns can be more volatile than index funds because of these concentrated bets on specific companies.

Bonds

These funds invest mainly in bonds sold by emerging-market governments, called sovereign bonds. They also invest in bonds of companies based in emerging markets, such as Qatar Petroleum Corp. and Russia’s Gazprom energy company. Some bonds are sold in the issuer’s home currency while others are sold in dollars, euros, and yen. These are known as hard-currency bonds. This removes the currency risk to U.S., European, and Japanese investors.

Emerging market bonds usually offer interest rates several percentage points higher than rates for U.S. Treasury bonds or U.S. corporate bonds with high credit ratings. The rate advantage can be offset or even wiped out by volatile trading prices, which are sensitive to any changes in the bond issuers’ perceived credit creditworthiness and concerns that the issuers might default on timely debt repayments.

As with stocks, some emerging market debt funds can be actively managed, or passive and simply track the performance of a benchmark index such as the J.P. Morgan Emerging Markets Bond Index.

Blend

Some emerging market funds have a blended portfolio. For equity funds, the blend may be growth stocks and value stocks. Bond funds may hold a mix of local-currency emerging market bonds and hard-currency bonds. And other funds may have both stocks and bonds. Still others may hold investments such as real estate and derivatives, which are securities and contracts tied to the value of other securities or assets.

Potential benefits and risks of emerging market funds

Emerging market funds can provide some potential benefits to investors, such as diversification. They include:

• Geographical diversification

  . Investors can expand their holdings beyond the leading industrialized countries. Some of the BRIC countries, as well as Taiwan, South Korea, and some eastern European countries, have more developed economies and financial regulations than other emerging markets.

• Portfolio diversification

  . Emerging market stock funds allow investors to spread risk in their portfolio, with returns that have low correlation, meaning they often don’t rise or fall in lockstep with U.S. or European stocks. Similarly, emerging market bond funds offer higher potential returns than U.S. or European funds, as well as low correlation.

• Professional management

  . Because the universe of emerging markets can change (due to some countries’ economic and political circumstances) some investments may become more or less appropriate for a fund. The fund manager’s analysis can determine if a change in the fund’s investments is needed.
  

At the same time, emerging-market funds have assorted risks:

• Inflation

  . An emerging market may experience high inflation stemming from government spending and taxation, which could prove difficult for the government to control. Inflation erodes investment returns, particularly for bonds.

• Currency

  . Fluctuations in the value of emerging market currencies affect the returns from foreign investments. A local currency that appreciates against the dollar can enhance returns for foreign investors, while a declining local currency will diminish returns.

• Liquidity

  . Emerging markets often are less liquid, meaning stocks and bonds can’t be bought or sold as easily as in developed markets. Prices may be less transparent and brokerage costs can be higher.

• Political

  . Corruption, unrest, or inconsistent government actions can jeopardize an emerging market investment. Chinese military threats to Taiwan independence or Russia’s invasion of Ukraine, for example, also may interrupt the functioning of emerging markets, leading some investors to reduce their holdings of emerging market funds.

The bottom line

Emerging market funds offer investors a variety of ways to own stocks and bonds in about two dozen countries that are considered emerging markets. Mutual funds may offer selected slices of emerging markets, while low-cost index funds provide investors with a broader representation of the securities in these markets.