When you're looking through global investments, it can be difficult to choose between an international stock mutual fund or an emerging market fund. It helps to understand what each one is and their differences so that you can decide whether to use them in your portfolio.
What Are Emerging Market Stocks?
Emerging markets are countries with rapidly growing economies that are generally "less developed" than larger or more established nations, such as the United States and Western European countries. Some of the largest countries that are considered emerging markets (by western standards) are China, India, Russia, Brazil, and Mexico.
In general, the market risk is higher for emerging markets than that of more developed countries. This risk is usually due to political instabilities, civil unrest, questionable accounting standards or unstable currencies. However, the higher relative risk generally provides higher potential returns.
What Are International Stocks?
International stock funds purchase several shares of stocks across developed countries and place them into a collection of funds. Many international funds follow indexes created from the best-performing stocks in broad geographic areas. For example, the MSCI EAFE Index tracks 874 stocks from many different countries.
Because developed countries have more robust and mature economies, there is less risk when investing in international stocks vs. emerging market stocks.
Interestingly, investors may find that many international stock funds invest in the same companies that domestic funds invest in—some of the top holdings for MSCI EAFE are from Nestle, Novartis, Toyota, Unilever and Sony.
Investors who access foreign investments through international funds reduce foreign investing risks through diversity, indexing, and familiarity.
Emerging Markets vs. International Stocks
Most investors deciding between buying emerging markets funds or some other international stock funds are looking for higher returns. Due to the higher relative risk, it's easy to believe that emerging market funds have better returns than international stock funds.
This is generally true in the short term. However, investors can also see low returns. In the long run, stock funds that don't concentrate on emerging markets tend to generate better returns based on economic stabilizing factors such as monetary policies from central banks and legislation enacted by the government to help consumers and businesses.
International stocks can have emerging market stocks mixed within them. The opposite is also true. It helps to study each fund's holdings to understand what you're buying.
It's important to remember that the returns of international stock funds and emerging market funds also depend on how they are managed. Fund managers of both types generally try to match an index, so one type might perform better than the other over different periods, but the risks will generally remain the same.
For instance, the Vanguard FTSE Emerging Markets Index Fund ETF Shares (VWO) price is higher than the Vanguard Total International Stock Index Fund Admiral Shares (VTIAX).
Holdings at the top of both types of funds include Tencent, Alibaba and Taiwan Semiconductor Manufacturing. The international fund has fewer holdings in any of the companies than the emerging market, making it more diversified.
Diversification, along with lower prices and steady growth, makes the global fund less risky and higher-returning in the long run, but your returns are slightly better with the emerging market fund in the short run.
So, you might get better returns in fewer years with the emerging market funds, but you spend more and take on more risk.
Neither investment is better than the other. Which is better for your portfolio depends on your risk tolerance, investment strategy and how much capital you have to dedicate to investing.
Invest in One, Both, or Neither?
Whether it is emerging markets or foreign stock, any international or emerging stock fund can be an intelligent part of a diversified portfolio of funds. Investors should be careful not to have more than 20% total exposure to stocks outside of the U.S.
Of that 20%, it might be wise to choose half emerging markets and half foreign stock for complete international coverage and more diversity.
Also, keep in mind that many foreign stocks invest in emerging markets countries. Therefore, one good foreign stock fund may already have sufficient exposure to emerging markets. Your strategy and comfort level dictate how you organize your global investments—it is possible to invest in one, both or neither depending on your preferences and portfolio.