There are a handful of investing principles that have stood the test of time but maybe none more so than the importance of diversification. For the average investor, diversification is more of a requirement than a recommendation. It reduces risks and increases the chance for greater long-term returns.
Not only should investors seek diversification in company sectors and investment types, but they should also look to diversify their holdings' geographical location. Investors who only focus on U.S. companies may be doing themselves a disservice because there are plenty of great investment opportunities outside of that market.
However, international companies aren't a monolith; different regions provide different benefits.
Image source: Getty Images.
How international markets are classified
International markets are typically divided into two categories: developed and emerging. Developed markets are countries with mature financial markets, well-developed infrastructure, and higher levels of industrialization. Emerging markets are countries with younger financial markets, developing infrastructure, and growing levels of industrialization.
Here are a few examples of where certain countries fall under this classification:
| Developed Markets | Emerging Markets |
|---|---|
| United States | China |
| Japan | Brazil |
| Australia | India |
| United Kingdom | South Africa |
| Netherlands | Mexico |
Source: MSCI Annual Market Classification Review.
While countries with developed markets and established infrastructure offer a bit more stability, emerging markets offer a unique opportunity. The early stages of economic transition mean they're less stable overall, but the rapid pace of development means there's plenty of room for growth opportunities -- and that's what makes them attractive.
What are emerging market funds?
As the name implies, emerging market funds focus their holdings on companies from emerging markets. They can take the form of exchange-traded funds (ETFs), mutual funds, or closed-end funds.
Investing in individual companies in emerging markets -- or international markets in general -- comes with inherent risks. Aside from the companies themselves, you have to consider the local economy, political stability (or lack thereof), and other unique challenges that wouldn't necessarily be at the forefront of your thoughts when considering a U.S. company.
Investing in an emerging market fund helps reduce some of this risk by essentially dividing it among its holdings. It can also provide diversification across sectors and countries, potentially giving investors broad exposure to growth opportunities in regions they may have otherwise overlooked.
Choosing the right emerging market fund for you
There are emerging market funds that focus on specific sectors, country-specific opportunities, and geographic regions, so which you choose depends on your investment goals and risk tolerance. However, a good go-to is an ETF similar to the iShares MSCI Emerging Markets ETF (EEM 0.07%) because it covers a lot of ground with a single investment. It contains over 1,200 stocks in the following markets:
- China: 29.80%
- India: 15.75%
- Taiwan: 15.27%
- South Korea: 12.12%
- Brazil: 5.31%
- Saudi Arabia: 3.96%
- South Africa: 3.08%
- Mexico: 2.33%
- Indonesia: 1.93%
- Thailand: 1.85%
- Malaysia: 1.40%
- United Arab Emirates: 1.32%
- Cash and/or Derivatives: 0.26%
- Other: 5.61%
For most of its existence, the iShares MSCI Emerging Markets ETF outperformed the S&P 500. Only in the past few years has its returns lagged the S&P 500, largely because of a sharp pandemic plunge. Look at its movements over the past two decades, and you can see the more volatile nature of emerging market investments.
Data by YCharts.
Investors need to approach emerging market funds with this reality in mind so they can be prepared for the roller coaster ride along the way.
For whom do emerging market funds make sense?
While they can be a productive portion of an investor's stock portfolio, emerging market funds aren't for every investor.
Generally, emerging market funds are best suited for investors with a longer time horizon. The growth opportunities can be lucrative, but they won't happen overnight (or in a few years). There will be inevitable volatility along the way, which may not work well for investors nearing retirement or with short time frames.
Additionally, investors with a moderate- to high-risk tolerance may be better suited to weather the inherent risks associated with emerging markets, such as political instability and economic volatility.
As with any investment, you never want to put all your eggs in one basket. If emerging market funds make sense for you, be sure they make up only a reasonable portion of your holdings. A well-balanced portfolio should always be the goal.
