Emerging Market Funds

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In the last article in this series, we looked at foreign versus domestic stock mutual funds. Emerging Market funds are a subcategory of foreign funds, but because of their increased risk and reward, they deserve some special consideration.

What’s an Emerging Market Fund?

Emerging markets are those countries in transition from politically-oriented markets to financially-oriented markets. These countries often have large populations, significant influence within their region of the world, and very high growth potential. Emerging markets include Brazil, Russia, India and China (known as the BRIC economies). Other large emerging markets include Pakistan, Turkey, Indonesia and Mexico.

Emerging market funds are a significant asset class in a diversified portfolio. In fact, in determining an appropriate asset allocation, you should distinguish between mutual funds that invest in developed countries and funds that invest in emerging markets. Why? Emerging market funds present considerable risk for a host of reasons, including the potential for political unrest. Along with that risk, however, comes the potential for substantial returns.

My Investment Experience with Emerging Markets

At the end of 2002, I invested in the Vanguard Emerging Markets Stock Index Fund (VEIEX). Now a confession. I didn’t really know what emerging markets were. I knew the fund invested in countries other than the U.S., but that was about it. I also didn’t know that in the six previous years, the fund had lost money in five of them. (My research since 2002 has come a long way.) Here are my returns from 2002 through the first half of 2007: 57%, 26%, 32%, 29% and 12% so far this year. Needless to say, I’ve been very happy with this investment.

But the truth is, I got lucky. Emerging market funds have been on a tear the last five years. They will lose money, and lots of it. Just look at the previous six years from 1997 to 2002, in which the fund lost money in every year but one (the one good year returned 61%, which should underscore just how volatile emerging market mutual funds can be).

When we get to actually building a portfolio later in this series, we’ll see how we can actually use risky investments to reduce (yes, I said reduce) the overall risk of a portfolio.

Some additional reading:

• The Next China: Five Emerging Markets to Watch @ Seeking Alpha
• New Portfolio Composition @ Investing the Middle Way
• Investing in Emerging Markets @ Money and Such
• Emerging market stocks: Back in the danger zone? @ Blogging Stocks
• Emerging Markets @ Random Roger’s Big Picture

Some books to consider on Emerging Markets:

You can check out all of the articles in my Beginner’s Guide to Asset Allocation series. You should also check out this article about frontier markets, the cutting edge of emerging market investing.

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