What it means
Emerging markets are economies that are growing and industrialising but do not yet have the depth, liquidity or regulatory maturity of developed markets. A fund gives an investor exposure to dozens or hundreds of companies across those countries in a single holding, which is far more practical than buying individual foreign shares directly.
The case for holding one is growth and diversification. Younger populations, rising consumption and rapid infrastructure spending can produce company earnings growth that is difficult to find in mature markets, and because these economies do not always move in step with developed ones, adding them can smooth a portfolio's overall path.
The risks are equally specific and worth stating plainly. Political change, weaker investor protections, commodity dependence, restrictions on moving money across borders and thin trading in a crisis can all produce falls far larger than a developed market index would suffer.
Currency is the factor most people underestimate. A fund can gain 15% in local currency terms, but if those currencies fall against the dollar the return in dollars will be materially lower, and in a bad year currency alone can turn a positive local return into a negative one.
Costs matter more than in mainstream funds because trading in these markets is expensive. Index trackers commonly charge somewhere around 0.2% to 0.7% a year while active emerging markets funds often charge over 1%, and that gap compounds heavily across a holding period measured in decades.
In practice
Real-world examples.
Example
A 34-year-old saver allocates 10% of her pension to a low-cost emerging markets index fund. She rebalances once a year, selling back to 10% after strong years and topping up after weak ones, and ignores the interim volatility entirely.
Example
A charity's investment committee reviews an active emerging markets fund charging 1.4% a year against a tracker charging 0.25%. After seeing five years in which the active fund failed to beat its benchmark after fees, the committee switches to the tracker.
Example
A family office holds an emerging markets bond fund for income rather than growth. When the dollar strengthens sharply, the fund's dollar value falls even though none of the underlying issuers missed a payment, which prompts a useful conversation about currency exposure.
Think of it
“Emerging markets fund invests in developing countries-higher growth, higher risk.
Formula
Calculation
Dollar return = ((1 + local-currency return) x (1 + currency change against the dollar)) - 1, then subtract the fund's expense ratio.
An investor puts $50,000 into an emerging markets fund. Over the year the underlying shares gain 15% in their local currencies, but the basket of those currencies falls 4% against the dollar, so each unit of local value is worth 0.96 of what it was. The gross dollar return is (1.15 x 0.96) - 1 = 1.104 - 1 = 10.4%. The fund charges an expense ratio of 1.2%, leaving a net return of 10.4% - 1.2% = 9.2%. The investor's gain is $50,000 x 9.2% = $4,600, so the holding is worth $50,000 + $4,600 = $54,600 at year end.Case study
Seen in the real world.
This is a fictional, illustrative example. The Marchetti Family Trust held $2,000,000 entirely in developed market shares and wanted broader exposure, so it invested $200,000 in an emerging markets fund with a 1.1% expense ratio. In the first year the fund fell 18% while the trust's other holdings rose, and two trustees pressed to sell.
The trust's adviser pointed out that the allocation had been sized precisely so that a fall of this scale would cost about 1.8% of the total portfolio, which was survivable by design. The trustees held, and over the following four years the position recovered and then exceeded its starting value.
The lesson the trustees recorded in their minutes was about position sizing rather than forecasting. They had no ability to predict emerging market returns, but they could decide in advance how large a loss they were willing to sit through without selling at the bottom.
Watch out
Common mistakes.
- Treating an emerging markets fund as a short-term holding. These markets can spend several years out of favour, so money that might be needed within five years does not belong here.
- Ignoring currency effects when comparing returns. A headline local-currency figure can differ from the dollar return by ten percentage points or more in a single year.
- Assuming the fund is diversified simply because it spans many countries. Some emerging markets indices are heavily concentrated in a handful of countries and a small number of very large technology and financial companies.
Questions
People also ask.
How much of a portfolio should sit in emerging markets?
There is no universal answer, but many diversified portfolios hold somewhere between 5% and 15%, sized so that a severe fall is uncomfortable rather than damaging.
Is an emerging markets fund riskier than a developed market fund?
Generally yes, with larger price swings, greater political and governance risk and added currency exposure, which is the reason investors expect a higher long-run return.
Should I choose an active fund or a tracker?
Active managers argue that less efficient markets reward research, but the higher fees are a certain cost against an uncertain benefit, so many investors start with a low-cost tracker.
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