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Look Before You Leap into Emerging-Markets Funds

These high-flying funds need to be approached as carefully as ever.

William Samuel Rocco, 06/16/2009

Emerging-markets funds have zoomed ahead of nearly all other types of offerings in this spring's worldwide equity surge. Sure, all five Morningstar Style Box categories of foreign-stock funds have gained roughly 48% from the outset of the current rally on March 10 through June 4, and certain other types of funds, such as natural-resources offerings, have delivered similarly impressive returns. But diversified emerging-markets and Pacific/Asia ex-Japan funds have both gained approximately 62% during the period, while Latin America offerings have returned more than 70%. Meanwhile, Russia and India offerings are up nearly 100% during the period.

The stunning gains of emerging-markets funds are partly due to investors rediscovering their appetites for risk and the fact that these funds fell quite sharply in the late 2007 to early 2009 global meltdown, giving them plenty of room to bounce back. (Some other types of high-risk offerings that suffered oversized losses in the meltdown have also snapped back sharply this spring.) However, the recent outperformance is also due to investor excitement about the superior macroeconomic conditions in the developing world. And most of the developing world's economic advantages over the developed world--such as its higher GDP growth rates and healthier demographic conditions--are expected to persist for years to come.

This is all encouraging, and a moderate dose of emerging-markets exposure does make sense for many long-term portfolios, but interested investors should approach this asset class with their eyes wide open.

Enough Emerging-Markets Exposure Already?
The first thing that investors should do is determine how much emerging-markets exposure is in their other equity offerings. For starters, most foreign large-cap funds have between 8% and 13% of their assets invested in the developing world; the majority of foreign small/mid offerings have similar percentages devoted to emerging markets; and many prominent foreign-stock funds currently have much bigger stakes in the developing world. Dodge & Cox International Stock DODFX, American Funds EuroPacific Growth AEPGX, and Janus Overseas JAOSX have more than 20% of their assets invested in emerging markets now, for example, as does Templeton Foreign Smaller Companies FINEX and AIM International Small Company IEGAX.

What's more, a good number of domestic-equity funds are willing to make significant investments in emerging markets. Meanwhile, a lot of foreign-stock funds are buying more or adding to their existing emerging-markets holdings these days, as are a few domestic-equity offerings. This means that many investors already have significant exposure to the developing world even if they don't own a pure emerging-markets fund.

Big Risks, Big Rewards
Investors who want more emerging-markets exposure should make sure that they fully understand the explosive nature of funds that focus on the developing world. This spring isn't the first time that these funds have skyrocketed in favorable climates. Indeed, they soared to huge absolute gains and handily outpaced all other types of funds in the early 2003 to late 2007 global rally, as a robust worldwide economy fueled strong demand for emerging-markets materials and products and as local conditions were constructive in most of the developing world.

However, because of the dependence of many developing economies on commodity prices, the sector concentration of most emerging markets, and other factors, these funds are extremely risky and prone to sharp declines in unfavorable environments. In fact, diversified emerging-markets, Pacific/Asia ex-Japan, and Latin America funds have been the most volatile types of international-stock offerings by far over the past decade. They suffered much more than other international-stock offerings during the late 2007 to early 2009 global crisis, losing about two thirds of their value, as demand for emerging-markets materials and products sank and local conditions weakened.

That rough period wasn't an isolated incident. All three categories of emerging-markets funds have suffered annualized losses of 20% or more during numerous rolling 12-month periods during the past decade--on top of those that occurred during the late 2007 to early 2009 meltdown.

There have been more up periods than down ones for these funds over time. Over the past decade, foreign large-cap funds have earned 1% to 4% annualized returns and foreign small/mid-cap offerings have posted 6% annualized gains, while diversified emerging-markets, Pacific/Asia ex-Japan, and Latin America funds have produced 10% to 15% annualized returns. And these 10-year returns are more indicative of emerging-markets funds' long-term potential than the huge gains that they posted this spring are.

Choose Wisely
The first impulse of many emerging-markets fans is to focus on funds dedicated to the developing world's trendiest exchanges or offerings that leave their competition in their dust during rallies. But as we pointed out last year and at other times in the past, single-country emerging-markets funds and other extremely bold emerging-markets offerings are problematic.

Single-country emerging-markets funds can't escape trouble in their chosen market and tend to be quite concentrated sectorwise, so they're prone to enormous losses when conditions turn against them. Russia funds lost nearly 80% of their aggregate value in the late 2007 to early 2009 crisis, as the government's errant moves and the market's big overweighting in commodity stocks compounded the difficulties facing all developing nations. Some regional funds, such as those that focus on Latin America and Eastern Europe, have weaknesses similar to those of single-country emerging-markets offerings. (Pacific/Asia ex-Japan funds are an exception to this rule because of the number, size, and diversity of the markets in their region.) And wider-ranging emerging-markets funds that employ very aggressive strategies tend to blow up in tough times, as their styles exacerbate the already significant risks of investing in the developing world.

Finally, the extra upside of the extremely bold emerging-markets funds doesn't always adequately compensate for the extra downside. And even when it does, the exceptional volatility of such funds ends up being more than many investors can handle. Thus, the best course for most investors who are seeking dedicated emerging-markets exposure is to focus on diversified emerging markets and Pacific/Asia ex-Japan funds that follow conservative to moderate strategies. Among broadly focused funds, American Funds New World NEWFX, Dreyfus Emerging Markets DRFMX, Lazard Emerging Markets Equity LZOEX and T. Rowe Price Emerging Markets Stock PRMSX are good ones that fit the bill. For Asia, Matthews Asian Growth & Income MACSX and Matthews Pacific Tiger MAPTX are worth a look. But even these funds require patience, so interested investors should have long time horizons, dollar-cost average in slowly, and keep their overall investments modest.

William Samuel Rocco is a senior fund analyst at Morningstar.

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