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Beware the Emerging-Markets Bandwagon

Most of the new emerging-markets funds can safely be ignored.

William Samuel Rocco, 05/03/2011

The number of emerging funds has been expanding rapidly. More than four dozen diversified emerging-markets funds have been launched in the past three years, in fact, raising the total number of such offerings to 150. In addition, many region-specific funds--China Region, Latin America, and Pacific Asia ex-Japan--have opened over this time span. There now nearly 80 regional emerging-markets offerings.

There are some good reasons for this. The growth rates and overall economic fundamentals have been better in the developing world than the developed world for several years, and those advantages are expected to persist. And the investment and regulatory climates have improved considerably in many developing countries in the 2000s, while the universe of public companies has increased significantly in number and quality.

But there also are ample grounds to believe that many fund companies are engaging in performance chasing: The four categories of emerging-markets funds earned huge gains and crushed all other types of mutual funds in the early 2003 to late 2007 worldwide stock surge, and they've performed similarly well in absolute terms and nearly as well in relative terms since the current equity rally began in March 2009.

The overall quality and attractiveness of the emerging-markets funds launched in recent years leaves something to be desired as well. Indeed, many of the newer diversified emerging-markets funds and nearly all of the regional emerging-markets offerings can safely be ignored.

Not Many Noteworthy Launches in the Diversified Emerging-Markets Group
Diversified emerging-markets funds tend to be attractive than the various categories of regional emerging markets. Because they can invest throughout the developing world, all emerging-markets opportunities are within their purviews and they're fairly diversified by country, sector, and stock. Thus, though they're quite volatile in absolute terms, these funds are the least volatile type of emerging-markets offering, and the easiest for investors to use.

A few of the newer funds, to be fair, do have substantial promise. For example, Northern Multi-Manager Emerging Markets NMMEX, which opened in November 2008, divides its assets among four subadvisors that boast lots of international and emerging-markets experience and that employ a mix of sound and complementary strategies. It provides broad exposure to the developing world, is reasonably priced, and has gotten off to an encouraging start. Thornburg Developing World THDAX, which opened in December 2009 and is available through advisors, comes from a family with a history of success with emerging-markets stocks and takes the same approach to security selection as an excellent foreign large-blend sibling. It has a nice balance of conservative and aggressive traits, has posted terrific results so far, and has a relatively moderate expense ratio.

But many of the newer funds have significant weaknesses. Several of them are pretty pricey, are from mediocre fund families, or are from solid shops without proven emerging-markets expertise. And a number of the rest have other limitations. Marsico is a fine firm, and James Gendelman had added a lot of value at Marsico International Opportunities MIOFX with his emerging-markets picks. But Marsico Emerging Markets MERGX, which was launched in December 2010, is being run by three former analysts without significant prior portfolio-manager experience. (One of the three was named a comanager on International Opportunities in November 2010.)

Hardly Any Appealing Launches in the Regional Emerging Categories
Regional emerging-markets funds have very narrow appeal by nature. In addition to making many good emerging-markets opportunities off limits, their geographic focus often leads to considerable sector and stock concentration (because the investment universes tend to be rather limited in any one or few emerging markets). And due to all this concentration, these funds are prone to performance extremes, and they should not be used as supplemental international holdings. In fact, they make sense only for risk-tolerant investors who already have a well-balanced portfolio of overseas offering and are seeking an extra bit of foreign spice for the very long haul.

Such investors will find that only a very few of the newer funds have clear merit. Matthews China Dividend MCDFX, which opened in late 2009, is one of this select set. Matthews is an all-Asia boutique that has an exceptional array of regional experts on staff and that has delivered strong risk-adjusted returns at a wide variety of multicountry and single-country funds. This one is run by Jesper Madsen employing the same distinctive--and relatively reserved--strategy that he has used to earned deliver impressive results at Matthews Asia Dividend MAPIX. It has delivered superior returns thus far and has a relatively moderate expense ratio.

But most of the newer funds have significant weaknesses. Many of them are rather expensive, are from fairly new or unexceptional fund families, or are from firms that have had success in other areas but have yet to demonstrate proficiency in the region or market in question. Meanwhile, some of the newer regional funds exacerbate the limitations--and risks of all such funds--by adding on another level of concentration. Front-load GlobalAfrica Infrastructure GAIAX and GlobalAfrica Natural Resources GANAX opened in August 2010, for example, while front-load Mirae Asset Asia Great Consumer MGCEX opened in November 2010.

Final Thoughts
Investors should keep three facts in mind as they consider the greatly expanded universe of emerging-markets funds. First, there are other types of international-stock funds that provide significant exposure to the developing world. Most foreign large-cap funds as well as most foreign small/mid-cap offerings devote to 10% to 20% of their assets to emerging-markets stocks, and many such funds invest even more in such issues. Thus, it's certainly possible to get a sizable stake in the developing world without owning a diversified emerging-markets fund, let alone a regional emerging-markets offering.

Second, while there are fairly slim pickings among the newer emerging-markets funds, there are several good options among the more-established offerings, most notably Morningstar's  Fund Analyst Picks. Third, realistic expectations and long time horizons are essential with all emerging-markets funds: The enormous gains that these funds have posted in the surges of the 2000s won't necessarily be repeated in future rallies, and even the tamest diversified emerging-markets funds incur big losses in tough times.

 

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