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You May Have More in Emerging Markets Than You Thought

Many funds are joining in the fun indirectly.

Kevin McDevitt, 07/06/2010

There's good news for those interested in capitalizing on growth in emerging markets--you probably already have more exposure than you think. When you look at where companies sell their products, not simply where they are domiciled or on what stock exchange their shares trade, an interesting picture emerges.

If you focus purely on conventional labels, most diversified foreign-stock funds or world-stock funds don't have significant emerging-markets stakes. The typical foreign large-blend fund has less than 8% of its assets in emerging markets, and the average world-stock offering has less than 7%. (Not surprisingly, the average foreign large-growth fund has far more--at nearly 15% of assets.)

Economic versus Equity Market Exposure
Because of these relatively small average weightings, the traditional view has been that to get significant emerging-markets exposure, investors would need to buy a diversified emerging-markets fund, or even a regional or single-country fund. This tied in with the notion that regardless of where a company does business, its stock price will usually move with its home market. This has tended to be true especially in the short run, where emerging markets have often moved together during corrections.

Over the long haul, however, a company's value will depend more upon its cash flows and less on where it is headquartered. With this in mind, many equity managers have been looking for companies that will benefit from economic growth in emerging markets, regardless of where those companies are based.

This is the idea, for example, behind American Funds New World's NEWFX unconventional approach. While the majority of its assets are invested in companies that are domiciled in emerging markets, a fourth to a half of its portfolio is typically found in developed-markets companies that do business in emerging markets. (The fund usually has 10%-20% of assets in bonds, too.)

This currently includes consumer-staples company Nestle. It's headquartered in Switzerland but derives about a third of its sales from emerging markets. About 40% of Spanish telecom Telefonica's TEF revenues come from Latin America.

Such Europe stocks, though, have been a slight drag on New World's performance, as emerging-markets equities have beaten developed-markets equities during the past decade. The fund has held its own, gaining nearly 9% annually. But the average diversified emerging-markets fund has gained nearly 10% per year over the past decade. Meanwhile, the typical foreign large-blend fund has struggled to keep pace with an interest-bearing checking account (that is, 0.22% annualized).PAGEBREAK

How Best to Play It
But while emerging markets' gross domestic product is almost certain to continue growing more quickly than developed markets' GDP, that doesn't guarantee that firms in developing countries are the only--or even the best--way to play that growth. Standard Chartered, for instance, is based in the United Kingdom, and its shares trade there; but it's a leading banker in Asia, the Middle East, and Africa, where most of its customers reside. On the other hand, Korea's Samsung Electronics gets about half of its revenues from developed markets.

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