January's Mutual Fund Red Flags

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

One of the hottest places to invest in recent years has been emerging markets. Rapid economic growth in China and India has caused money from around the world to pour into emerging-market stocks, resulting in some truly impressive returns. Three Morningstar categories that focus on emerging-market stocks-Pacific/Asia ex-Japan stock, Latin America stock, and diversified emerging markets-each had average returns of more than 30% in 2007, surpassing all other categories for the year and over the trailing three- and five-year periods. Such supercharged returns are great for shareholders while they last, but eventually the good times will have to come to an end. Exactly when that will happen, and whether it will be a slow unwinding or a jarring crash, is anybody's guess.

It's not just funds in these narrow categories that invest in emerging markets, however; many foreign funds have big holdings in such stocks. If a foreign fund you own has huge three-year numbers, it probably has a lot in emerging markets. Here are some diversified foreign funds with emerging-markets stakes of at least 15%. These are all good funds that have posted great recent returns, but those returns have come with risks that investors should not forget.

Janus Overseas JAOSX
This fund sports an annualized five-year return of more than 31%, putting it near the top of the foreign large-growth category. A 28% stake in emerging-markets stocks such as Reliance Industries (from India) and Cyrela Brazil Realty has been a big factor in those returns, especially over the past three years. A similarly aggressive strategy also led to big gains for the fund in the late 1990s under former manager Helen Young Hayes before it fell to earth, losing an average of 23% annually from 2000 to 2002. Current manager Brent Lynn has not let the fund's risks get out of hand, but shareholders should still be prepared for the possibility of a short-term downturn.

T. Rowe Price Global Stock PRGSX
Manager Rob Gensler has put together a great record at this fund since taking over in April 2005, outpacing the world-stock category by a wide margin. Gensler, who previously guided T. Rowe Price Media & Telecom PRMTX to stellar results, has made this fund bolder and more concentrated, with emerging-markets telecom stocks such as America Movil AMX and Bharti Airtel among its top holdings. Although he has recently tried to dial down risk, almost a fourth of the portfolio is still in emerging markets. We're still big fans of Gensler and the fund, which remains an Analyst Pick in its category, but investors should keep its emerging-markets stake in mind when fitting it into their portfolios.

Julius Baer International Equity BJBIX
This $25 billion fund has one of the best records in the foreign large-blend category, which it has beaten in 12 straight calendar years. Managers Richard Pell and Rudolph-Riad Younes have achieved these results with a flexible strategy that often leads to unconventional corners of the market. For example, the fund's 23% emerging-markets stake is relatively light in emerging Asia but heavy in Central and Eastern European banks. We'd be hesitant to bet against these managers given their record, but the fund's big emerging-markets stake and its above-average volatility mean that investors should be prepared for the possibility of some short-term bumps, especially if emerging markets take a dive.

William Blair International Growth WBIGX
Manager George Grieg has put together a great long-term record since taking over here in 1996. His wide-ranging strategy often involves significant stakes in emerging markets, which currently make up 15% of the portfolio. The fund has handily beaten the foreign large-growth category over the trailing five years with annualized returns of nearly 25%, but a fall in emerging-markets stocks would likely cause those returns to suffer.

David Kathman is an analyst with Morningstar.