Herding in Emerging Market Funds

Herding in emerging-market funds is especially pronounced because retail and institutional capital chases yield, narrative shifts, and perceived risk appetite—moving in and out of entire market complexes in tandem. When confidence wanes, withdrawals are simultaneous, forcing local currencies to crater and rates to spike, turning modest slowdowns into crises for the frontier economies themselves.

Why emerging markets are herd-magnets

Emerging-market funds offer yield and growth unavailable in developed economies. A Brazilian corporate-bond yields 8%, a Mexican government bond yields 10%, a Vietnamese equity trades at a 15% free-cash-flow yield. To a pension fund earning 1–2% in U.S. treasuries, these numbers are intoxicating. Institutions can justify the allocation: diversification, expected growth rates, long-duration liabilities.

But therein lies the trap. The moment that U.S. yields rise, or the Fed signals tightening, or a recession risk emerges, that same yield looks less attractive relative to the risk of a currency collapse or default. Suddenly, exiting emerging markets is no longer a niche trade—it is a stampede. All the money that piled in because of yield looks to exit simultaneously.

The herd forms because the decision rules are nearly identical across institutions: if U.S. rates are rising and emerging-market spreads are not widening fast enough, sell. When thousands of funds follow this rule in lockstep, liquidity vanishes and local markets gap down.

Currency depreciation and carry-trade unwinding

Many emerging-market investments are implicitly carry trades: borrow in low-yielding dollars, invest in high-yielding emerging assets, pocket the spread. As long as the currency stays stable or appreciates, the trade prospers. But when risk appetite drops and flows reverse, the local currency gets hit first. The Brazilian real, the Indian rupee, the Turkish lira can depreciate 20–30% in weeks when the herd exits.

Currency depreciation then hits the local economy hard:

1. Imported inflation: Countries that import oil, technology, or consumer goods face spiking prices, feeding into broader inflation.
2. Debt servicing: Many emerging governments and corporations borrowed in dollars. A depreciated currency means higher local-currency costs to repay. Defaults accelerate.
3. Capital flight feedback loop: As inflation and defaults rise, locals also try to move money out—exacerbating the depreciation.

The Asian crisis of 1997 followed this pattern: external borrowing, currency peg breaks under speculative pressure, defaults, crisis. The 2013 “taper tantrum”—when the Fed signaled it might slow quantitative easing—briefly sparked 15–20% selloffs in emerging-market currencies.

Boom cycles disguise deteriorating fundamentals

In the boom phase of the herd cycle, emerging-market governments and corporations borrow heavily at cheap rates. They may spend on infrastructure, social programs, or buybacks. Growth looks solid on the surface. But if borrowed at fixed rates (often in dollars), the fixed-rate-payment obligation is a future liability—one that becomes crushing if growth slows or currencies weaken.

Additionally, commodity-dependent emerging economies see their export revenue skyrocket during boom times, encouraging massive fiscal spending or private investment. Thailand and Indonesia binged on exports and credit during the 1990s boom; when the crisis hit, revenues cratered while spending and debt remained. Unemployment spiked, and a recession became a depression.

Similarly, the 2010s carry-trade boom into emerging markets was driven by zero rates in developed economies. Investors could borrow at 0.5% in dollars and earn 6–8% in emerging assets. Every quarter that global growth seemed stable, more flows arrived. Leverage built up. When the U.S. shifted to rate hikes in 2022, the unwinding was brutal: emerging-market currencies fell, equities sold off, and many frontier borrowers faced refinancing crises.

Momentum and narrative herding

Beyond yield carry trades, momentum and sentiment also drive herd movements. If emerging markets rallied last quarter and a positive headline about Chinese growth emerges, inflows accelerate. Funds chase recent performance. Conversely, a missed earnings forecast or a political crisis can spark a shift in narrative: from “emerging markets are attractive” to “emerging markets are risky.” Once the narrative flips, selling is reflexive.

This was evident in 2020–2021. COVID crashes triggered mass outflows; emerging markets, seen as risky, got hammered first. But low rates and stimulus reignited carry trades. Funds that had exited piled back in. By 2021, the narrative was “emerging-market recovery + commodity supercycle.” The herd pushed valuations to stretched levels. In 2022, the reversal was sharp: rate hikes, dollar strength, recession risk—all triggered simultaneous exits.

Local economic consequences

Herding cycles are not costless to the countries involved. Multiple sudden reversals create:

• Banking crises: Local banks borrowed short and lent long; sudden capital flight can drain liquidity and trigger bank runs.
• Unemployment: Investment dries up; businesses cut hiring as credit tightens and currency weakness raises import costs.
• Political instability: IMF bailouts and austerity measures are unpopular. Governments fall. New regimes may default or impose capital controls.
• Lost development: Countries that rely on herding-prone capital for growth end up stop-and-start; long-term investments (education, infrastructure) get deferred or abandoned during busts.

The Philippines, Indonesia, Brazil, and Turkey have each suffered multiple cycles of boom-bust herding that set back development and institutional credibility.

Identifying herd extremes

Investors monitoring emerging-market exposures watch for:

• Inflow extremes: Fund flows turning positive after years of outflows; emerging-market ETFs seeing record inflows.
• Valuation disconnects: Emerging-market multiples rising despite flat or falling earnings, or currency strength despite rising interest rates (both suggest momentum, not fundamentals).
• Leverage build-up: Measuring dollar-denominated debt relative to export earnings; when the ratio is at decade highs, the herd is betting on stable or rising currencies.
• Fed pricing: When markets price near-zero recession odds and expect low rates indefinitely, emerging markets are extended. The herd is crowded.

During these extremes, diversified investors trim exposure and raise cash, rather than chase momentum.

See also