Many investors who seek higher returns over time have become frustrated with the continual pullbacks that have plagued our domestic markets in recent years. And while foreign exposure does continue to provide a measure of diversification, the variance between the U.S. markets and markets in Europe and the Far East has lessened over time because those markets have matured to the point where they now move much more in tandem with our markets than they once did.

Investors who seek true international diversification must now look more to emerging market economies in order to get the results that they seek over time. However, this segment of the world economy comes with risks that are commensurate with its returns, and investors need to do their homework and be prepared for the subsequent volatility that they will experience in their portfolios.

Be sure to also see our Beginner’s Guide to International Mutual Funds.

Although there is no absolute definition for what constitutes an emerging economy, most experts consider this to be the economy of a country that is moving from a closed to an open system and has not matured to the point where it can be classified as developed. About 60% to 80% of the world’s population and somewhere between 20% and 45% of the global economy falls into this category, depending upon how it is classified.

Most of the countries that meet the criteria for this definition are experiencing rapid and substantial economic expansion. Some examples of this include China, Brazil, Mexico, India and Russia. Needless to say, the combined potential for growth in just these countries is staggering. In many respects, these countries represent the future of global GDP because of their continued potential for expansion. The populations of these countries represent vast markets for foreign products (such as from the U.S.) as their median incomes continue to rise.

Take our quiz – Which Country Has a Higher GDP?

Unlike some types of mutual funds that can be used to satisfy two or more investment objectives, such as growth and income, emerging markets funds should be viewed solely as vehicles for long-term aggressive growth in most cases. Investors who purchase these funds need to be able to weather above-average volatility and substantial market corrections in order to receive the superior long-term growth that they provide.

Emerging market funds can also add a substantial measure of diversification to a portfolio, as they have a considerably lower correlation to our markets than more developed overseas sectors. Some mutual funds of this type purchase securities from issuers in emerging markets, and these will typically fall into the high-yield category, as their holdings tend to carry a higher risk of default. It is important to note that emerging markets mutual funds of any type also come with some fairly unique risks that do not apply to domestic funds. Political actions and domestic unrest can substantially impact the returns that investors receive, and a radical change in leadership or policy can easily result in unexpected gains or losses for investors.

Foreign currency exchange rates can play a major role in the performance of these funds as well. Some funds focus on specific segments of the market as a whole (i.e. common stock, secured debts, etc.), while others concentrate on a specific region, such as the developing countries in the Far East or South America. There are also both open-ended and exchange-traded funds that invest solely in individual countries; the ETFs that do this typically hold the entire basket of securities that are traded on that country’s largest stock exchange. Investors who hold these funds may also have to pay tax on foreign income that is reported to them on the 1099-DIV and 1099-INT forms.

See also a Beginner’s Guide to Currency Mutual Funds.

Mutual funds are a great way for investors to get into emerging markets for several reasons. This is definitely one sector where the research, education and other tools that professional portfolio managers have at their disposal can typically enable them to select and manage a portfolio much more effectively than individual investors, as the information that is required to make intelligent decisions in this area may be rather difficult for those outside the institutional arena to come by. The other standard advantages of liquidity, tax reporting, diversification and reduced expenses from economies of scale apply here as well.

See also The Cheapest Mutual Funds for Every Investment Objective.

Investors who are looking to get into this segment of the market through mutual funds have many competitive alternatives from which to choose. A cursory list of some of the most well-known emerging markets mutual funds to invest in:

• Van Eck Emerging Markets A (GBFAX) – This large-cap growth fund invests heavily in stocks outside the U.S. with a concentration in the financial and technology sectors. It charges a maximum sales load of 5.75%, and Morningstar classifies its annual expense fees as below average and gives this fund 3 stars.
• Wells Fargo Advantage Emerging Markets Equity A (EMGAX) – Morningstar gives this fund 3 stars as well and also classifies its annual expenses as below average. It also charges a maximum load of 5.75%, but this fund falls into the large-cap blend category. While its portfolio is also heavily invested in the financial services sector, it has a higher concentration of defensive consumer staples than technology.
• Invesco Developing Markets A (GTDDX) – This fund is currently awarded 4 stars by Morningstar and charges a maximum 5.5% sales load with low annual fees. This large-cap blend fund is by far the most heavily concentrated in financial services holdings.
• Vanguard Emerging Markets Stock Index Fund (VEIEX) – This no-load large cap blend fund has been given 3 stars by Morningstar and boasts exceptionally low annual expenses. Its portfolio is also most heavily concentrated in the financial and technology sectors.

Emerging markets mutual funds can provide substantial rewards to investors seeking aggressive growth and diversification in their portfolios. However, these funds also come with some unique risks, as they are subject to political upheaval and fluctuations in currency exchange rates.

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