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Risk-Conscious Ways to Make Emerging-Markets Plays

These attractive emerging-markets funds provide a relatively smooth ride.

William Samuel Rocco, 07/21/2010

Developing countries have enjoyed quite positive economic and demographic trends during the 2000s. Governmental policies and corporate practices have also improved considerably in many emerging markets the past decade. Equity funds that focus on the developing world have capitalized on these favorable conditions. The average diversified emerging-markets fund has earned a 10% annualized gain over the past 10 years, while the typical foreign large-blend, foreign large-growth, and foreign large-value offerings have posted 0.0%, 0.3%, and 2.3% annualized returns, respectively.

Most experts say the economic, demographic, government, and corporate conditions in the developing world will continue to improve for years to come. There are ample grounds, therefore, to be hopeful that diversified emerging-markets funds will produce good returns and outpace foreign large-cap offerings over the long run. (Diversified emerging-markets funds are unlikely to beat foreign large cap by as much over the next decade as they have over the last one, though, as the 2000s were exceptionally poor for most developed-markets stocks.)

All this makes diversified emerging-markets funds enticing, but such funds come with real risks. In fact, they have had a more tumultuous ride than most other categories of funds in 2010--and they were slightly in the red for the year to date through July 16--because worries about inflation in China and Brazil and other concerns have hurt stocks in those two and many other developing nations. Meanwhile, the rough spells have been more severe and somewhat common in the past. These funds lost nearly two thirds of their value in the late 2007 to early 2009 worldwide sell-off, due to anxiety about a global recession and apprehension about valuations and local challenges in many developing nations. And they've been much more volatile over time than all categories of international-stock offerings, except regional emerging-markets funds.

But investors who'd prefer to take on somewhat less risk while making a long-term play on the positive conditions in the developing world do have some good options. They fall into three camps: emerging-markets stock funds with strict stock-selection disciplines, emerging-markets stock offerings that take open-minded approaches to the asset class, and emerging-markets bond funds.

The Strategy Does the Trick Here
The funds in the diversified emerging-markets category are no different from those in most other equity groups in that they employ a wide range of stock-selection styles. Those at the bold end of the spectrum in this category tend to do things like pay up for issues, favor hot sectors and countries, and run a concentrated portfolio of names, while those at the tame end of the spectrum tend to pay considerable attention to valuations, go light on trendy industries and nations, and spread their portfolios across a considerable number of names.

Dreyfus Emerging Markets DRFMX stands out among the funds with conservative stock-selection styles. Manager Kirk Henry won't consider a stock unless it is trading at a sizable discount to its home market and global competitors and it has a catalyst for improvement, as well as good long-term prospects. What's more, he promptly sells holdings once he thinks they're fully valued; he's quite comfortable with modest weightings in trendy areas; and he owns more names--and invests fewer assets to his top 10 holdings--than most of his peers. Henry has put these temperate traits to effective use: This fund has held up much better than most of its peers in downturns and has been significantly less volatile than its average rival over time. And thanks to his stock-selection skill, it has earned superior long-term returns.PAGEBREAK

Flexibility Moderates Risk in This Case
While Dreyfus Emerging Markets and the vast majority of other funds in the diversified emerging-markets category focus on the stocks of companies domiciled in the developing world, a few funds in the group take a more expansive view of the asset class. American Funds New World NEWFX is the most prominent and attractive of these more-flexible offerings. Its managers invest in emerging-markets stocks and bonds, as well as the equities of firms that are headquartered in the developed world but have significant ties to the developing world.

Emerging-markets bonds and developed stocks, which normally make up 30%-50% of assets, are far less explosive than emerging-markets stocks, and the managers employ a sensible approach to security selection and spread the portfolio pretty evenly across hundreds of issues. Not surprisingly, American Funds New World has held up much better than most of its rivals in sell-offs and has been the least-volatile member of its category over the long run by far. And though its conservative style has certainly been a burden in emerging-markets rallies, its longer-term returns are in line with the group averages.

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