Compelled by the collapse of the financial system in 2008, investors were forced to reevaluate their overall portfolio allocation in terms of both asset type and region exposure. The quick response of many investors was to abandon equity and reallocate that capital toward fixed-income products in hopes of insulating themselves from any further downward shifts.

From Oct. 31, 2008, through the end of 2011, U.S.-based fixed-income funds experienced roughly $664 billion of net inflows. In comparison, equity funds reported net redemptions of $121 billion over the same period, while the subgroup of domestically focused products recorded staggering outflows of $251 billion. Interestingly, outside the domestic equity space, there were some actual stock fund inflows ($130 billion net); $59 billion, or roughly 45% of those, went to emerging market equity offerings.

Growth Potential
So with the risk aversion over the last few years, why do we continue to see investors allocating large amounts of cash to emerging market stock portfolios? First, global financial markets have become increasingly integrated. The wide reach of multinational companies, the globalization of our banking systems and the greater distribution of wealth in undeveloped nations has created an investment environment that offers more options to help diversify investment portfolios. With these developments has come a general trend of investors allocating more of their equity exposure outside the United States, with a portion favoring companies within developing nations.

We can see this shift by looking at the MSCI All-Country World Index as a proxy; in 2001, emerging-market companies represented only 3.4% of the index's market cap. Fast forward to the end of 2011, and that weighting increased to 10.7%. So, over the last 10 years the global index has increased its emerging market exposure nearly 215%, a move that has been matched or closely matched by managers who benchmark to it (see Figure 1).

Second, during this time, more asset managers have constructed portfolios that provide the additional diversification and growth potential of up-and-coming nations. From the end of 2001, the emerging-market fund universe has gone from 94 distinct fund products to 165 at the end of 2011.

Assets under management in the U.S. began that same period at roughly $32 billion and ballooned to $193 billion by Dec. 31, 2011. That is an increase of more than 503%. Much of this increase was due to a strong performance track record, but net sales also supported the expansion throughout the period.

Focusing more on performance, emerging-market funds have boasted one of the best 10-year track records among all Lipper equity groups. With a 10-year annualized average return of 12.9% through Dec. 31, 2011, the group was bested by only four other less diversified groups—precious metals funds (+19.9%), Latin American funds (+17%), India region funds (+14.1%), and global natural resources funds (+13.3%)—two of which represent subregions of the more diversified emerging-market products themselves.

As of the end of 2011, Brazil carried the most favor with portfolio managers. Its weighting in portfolios was roughly 13.7%, followed by South Korea (10.7%) and China (8.5%)—not too surprising as Brazil just recently overtook the United Kingdom as the world's sixth largest economy.

Despite this spectacular run, investors must be wary because it has not always been a smooth ride. The emerging-market regions haven't been immune to sudden and sharp downturns; in 2008 the group lost an average of 55.2%, and again more recently in 2011, it ended the period down 20.1%.

So although emerging-market funds are often seen as a strong diversification from developed-market products, both advisors and clients must take into consideration their higher risk profile. Looking at the five-year period that included these downturns, emerging-market funds were in the 10 top Lipper equity classifications for risk as defined by five-year annualized standard deviation at the end of 2011. With 29.25% on average, the classification came in noticeably higher than more widely diversified funds in international multi-cap core funds (22.69%) and global multi-cap core funds (20.77%) groups.

This added volatility is worth noting, but should not be news. Looking at the risk disclosures in any emerging-market fund prospectus should tip us off to the added risk exposure. Often lumped under "emerging-market risk," terms such as economic, political, liquidity, derivative and currency risk abound. Although these possible downsides are also present in developed markets, many more emerging markets have recent histories of such problems, and risk disclosures should not be seen as simply legalese but as descriptions of possible outcomes. One specific risk that is an issue with any international investment is currency risk.

Much of the performance I spoke of earlier may result from emerging-market currency appreciation. Not only do portfolio managers have to consider the growth prospects of the companies in which they are looking to invest, they must also be aware of macroeconomic events that may create shifts in exchange rates and the costs/gains that come with repatriating investor capital.

Figure 2, shows the five-year performance of select MSCI emerging-market indexes, calculated in local currency versus the U.S. dollar. As shown here, performance profiles can take a much different shape because of these fluctuations. India, where the positive gain turns negative once repatriated to dollars, is a good example. So, why do we continue to see such large allocations of cash to emerging-market products? Diversification and past performance aside, many investors are looking to position themselves for the future.

Another outcome from the 2008 recession was the hard realization that developed markets can no longer be relied on as global drivers of growth. Attention has now shifted to the developing nations, where economic strides have set off a series of chain reactions. Growing middle classes have led to greater purchasing power, which has led to increases in consumer demand and corporate growth. The growth of emerging-market capitalism has created an opportunity for investors to participate in what many see as the future drivers of global economic development and corporate profits.

Of course, many of these future prospects will be dependent on how emerging economies develop and whether they are able to create and maintain liquid markets. Inflation and debt controls will continue to draw investor attention. But the hope is that as time goes on, investors will reap the benefits of growth from these markets as they integrate with global markets and as their risks begin to decrease. There will always be the next up-and-coming segment: frontier markets that allow investors to seek riskier prospects. But until the larger emerging economies (Brazil, India, China, Russia) shift themselves into the developed column, much of the focus will still be on them.

Matthew Lemieux is a research analyst at Lipper.