Emerging markets are a top investing trend for 2023. Here's the best way to take advantage

Published Mon, Jan 23 202310:05 AM ESTUpdated Mon, Jan 23 202311:49 AM EST

After a dismal performance for stocks and bonds in 2022, Wall Street is looking outside of the U.S. for growth this year. Emerging markets, which include countries such as China, India, Brazil, are a top area where money managers are investing in hopes of seeing gains that outpace the U.S. The trend is having a resurgence after also underperforming in 2022. Investors are buying into the trade in droves. Last week, Bank of America investors put $12.7 billion into emerging-market debt and equity funds, the largest inflows ever, according to a note on Friday. The move was prompted by China's reopening, investment strategist Michael Hartnett wrote. That's a pivot from just a few months ago, when investors were steering clear of China due to its zero-Covid policy. "Last year was a bit like the peak of pessimism because we had the largest country, China, where everything went wrong," said Laurence Bensafi, portfolio manager and deputy head of emerging-markets equities at RBC Global Asset Management. But investor sentiment is now changing as China's economy gets going again. Performance has been strong so far this year. The iShares MSCI emerging markets Asia exchange traded fund is up 11% and the iShares core MSCI emerging markets ETF is up more than 10% since the year began. IEMG YTD line Emerging market performance ytd The trend is poised to continue as central banks around the world boost interest rates to tame high inflation and contend with potential economic recessions. "We feel we are in another switch, another period where we're entering a new regime and we're going to have higher inflation for longer, higher interest rates, higher commodity prices and all of that is going to be more positive for emerging markets," said Bensafi. Investing trends While there's promise in the emerging-market trade, it can be difficult for retail investors to invest in other countries without seeing returns eaten up by fees. Still, it is worth some extra time and attention to capture the potential upside and diversify one's portfolio. "Investors really have to look elsewhere for sources of diversification and sources of returns," said Nathan Kotler, head of trading at GenTrust. "I think one of the hard lessons that investors learned in 2022 is that equities don't always go up and U.S. equities don't always outperform other markets." There are a few major trends investors are looking at. For Kotler, it's emerging-market bonds, where his firm has an overweight rating as opposed to a neutral rating on equities. This is because yields have come back up in the bonds space and are looking attractive, he said. China is another market that has drawn investor interest. At this point in the coronavirus pandemic, the country and especially the leading party needs to have a new economic plan to rebuild, according to Rhys Williams, chief strategist at Spouting Rock Asset Management. "We think at least for the next year the grass will be greener in China," he said, adding that the biggest headwind that should become a tail wind is the reopening and rolling back of Covid policies. "We expect the restart of China is going to really affect the whole world, and that will happen maybe as early as February," said Williams. He's also looking at Brazil following the election of Luiz Inácio Lula da Silva, as well as some smaller countries including Thailand. One other factor that should help emerging-market countries outperform is the winding down of the strength of the U.S. dollar. In 2022, the strong dollar weighed on emerging-market debt, which is often denominated in dollars. This year, however, that strength should see a pullback, making debt less expensive for those countries. How to invest Experts generally recommend that investors look at funds that hold broad baskets of emerging markets for diversification and exposure to the entire trend instead of picking individual stocks or countries themselves. "Timing which country is going to do well at which point in time is very difficult," said Gaurav Mallik, chief investment strategist at State Street Global Advisors. "It's good to get broad exposure." Passively managed index funds can be a good idea for investors as they're generally lower cost than actively managed ones and tend to be more tax efficient, said Kotler. Bond funds also tend to have lower expense ratios than mutual funds, he added. Some top emerging-market bond funds include the iShares JP Morgan USD Emerging Markets Bond ETF , the Vanguard Emerging Markets Government Bond ETF and the VanEck JP Morgan EM Local Currency Bond ETF. There are also equity opportunities as well that are currently looking cheap compared with other stocks, Mallik said. One top fund recommended is the iShares core MSCI emerging markets ETF. This includes broad coverage of emerging markets with a relatively low expense ratio of 0.09%, said Aniket Ullal, the vice president of ETF data and analytics at CFRA Research. Of course, the downside to large emerging-market funds is that they tend to be most heavily weighted to China, the largest emerging market country. For investors who want to avoid China, or who want to be able to pick more carefully, there are a few other options. Those interested in investing in Latin America should consider the Franklin FTSE Latin America ETF, which has a 0.19% expense ratio, or the iShares Latin America ETF , which has an expense ratio of 0.47%, per Morningstar data. The Franklin Templeton ETF is the one Ullal prefers because it has a lower expense ratio and is a bit more diversified than the iShares fund — it has more than 150 holdings opposed to about 40 for the iShares one. They both have similar regional exposures including about 60% of stocks from Brazil and 25% to 30% from Mexico. Investors looking to focus on just one or a few countries without broad exposure could look at country-specific ETFs including the iShares MSCI China ETF (0.58% expense ratio) or the iShares MSCI India ETF (0.64% expense ratio), he added. There are also smaller-cap options for investors who want to include more than just large-cap names.