Emerging Market Funds: An Overview

Introduction

Emerging market equity funds invest in those global economies that are at the cusp of a transformation. These countries are in their transition period and are expected to perform as they progress. While the term ‘emerging market’ is subjective, it typically refers to the countries tracked by the MSCI Emerging Market Index. Just like mutual funds and exchange traded funds (ETFs), emerging market funds also follow different strategies of investment.

What are Emerging Market Funds?

An emerging market is an economy that is on a rapid growth trajectory with respect to scale as well as size. The underlying expectation behind emerging market investments is that these countries will soon become developed nations. According to the March 2023 factsheet, five countries together constitute 78% of the weightage in the Emerging Markets Index. They are China, Taiwan, India, South Korea and Brazil in descending order of weight.

Although these countries offer immense growth potential, they are still high-risk economies. Investing in emerging markets helps investors diversify their portfolios across the risk spectrum. Hence, as the name suggests, emerging market funds are mutual funds that invest in various securities of developing countries. These securities can be equity, debt, or ETF investments. Investors can choose between active and passive funds, depending on how much human involvement they wish to allow.

How do Emerging Market Funds Work?

Emerging markets generally witness a rapid evolution in their infrastructure due to their fast-growing businesses. Growth-stimulating factors are macroeconomic conditions, political stability, geopolitical developments, bilateral relationships, etc. Emerging market funds invest money across countries, sectors, industries, and market capitalisations. By doing so, fund managers diversify investor portfolios across a wide array of risk profiles and performance paces.

For instance, a fund manager may spot growth opportunities in Brazil after the OPEC+ oil production cut and choose to invest in the oil & gas segment of that emerging market. Based on in-depth research and international developments, such investment decisions are made and asset allocation is firmed.

It is worth noting that countries that are transforming at a high pace are also prone to quick political power shifts, asset price fluctuations and also monetary policy. This is what makes them riskier than developed economies where such vulnerabilities rarely become a cause for concern.

There is another risk associated with investments in emerging market funds – currency risk. When the sovereign currency of a nation is weak and volatile, it may cause a significant shift in value relative to the US Dollar. However, this may change in the near future as countries are keen on moving away from this dollar dependency and are forming trade relationships that use alternate currencies. Thus, emerging market funds not only hedge market risk but also forex risk by being cognizant of foreign currency exposure.

Types of Emerging Market Fund Securities

There are three major types of securities in which emerging market funds dabble:

1. Equities: These funds invest money in the stocks that offer scope for capital appreciation over the long term. The focus of an equity emerging market fund could be the stocks from one industry but different geographies or the same geography and different industries or sectors. The flexibility allows hedging of risk.
2. Debt: These are typically bonds issued not only by private enterprises but also governments of emerging market economies. Bonds are generally issued by entities looking to raise debt capital for the short and long term.
3. Hybrid: Such emerging market funds distribute their investments across both the above kinds of securities. This arrangement helps the fund make gains from a fixed income as well the capital gains from equity investments, which is a mix of value and growth investments.

Factors to consider before investing in Emerging Market Funds in India

Prior to investing, businesses are generally classified into three buckets – developed, emerging and frontier, based on the stage in development. Frontier companies are at the precipice of transformation and are yet to commence their growth story. These are, therefore, less stable, and much riskier than those hailing from fully developed geographies.

Developed countries or industrial nations are those that have already fulfilled their technological requirements and have established all the necessary infrastructure. These are the most stable and least risky of the three.

Emerging economies harbour companies that are further along the growth journey than frontier companies and are hence more stable. Although these are less risky compared to frontier companies, it is still a significant amount of risk but with the added scope of significant gains as well.

One must also consider the inflation scenario of emerging markets. Since these are fast-paced and growing, it often leads to a quick rise in inflation. Moreover, the risky nature of investment also means low trading volumes and therefore low liquidity in the markets. These factors play a key role in deciding the right place to park money.

There is also the risk of political stability and regulatory friendliness. Emerging markets are prone to power shifts and thus are also susceptible to monetary policy changes when this happens. This adds institutional and political risks to emerging market fund investments.

All the above risks and classifications must be carefully evaluated before deploying money into these funds.

Conclusion

Emerging market fund investments require patience and risk appetite. These markets take years to grow and are also risky. Due to this nature, investors who have a long-term horizon in mind with a tolerance for risk should park their money in emerging market funds. And as is always, thorough research about the target market must precede any kind of investment decision.