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Approach Single-Country Emerging-Markets Funds With Your Eyes Wide Open

These funds come with notable risks as well as ample potential rewards. 

Samuel Rocco, 05/01/2012

The universe of single-country emerging-markets funds continues to expand. Indeed, since the start of 2011, 11 funds that focus on China, nine offerings that concentrate on India, three Brazil funds, and a half dozen portfolios that focus on other individual developing countries have opened. There now are 53 open-end fund and 66 exchange-traded funds dedicated to individual emerging markets.

These funds are growing in size as well as in number. Nine of them have $1 billion or more in assets, including Fidelity China Region FHKCX, Market Vectors Russia RSX, and iShares MSCI Brazil Index EWZ (which has more than $9 billion in assets). Ten more of these funds have between $500 million and $1 billion in assets, including Matthews India MINDX, iShares MSCI South Africa Index EZA, and iShares MSCI Malaysia Index EWM.

The increased availability of, and interest in, single-country emerging-markets funds is not very surprising. For starters, many developing countries boast an abundance of macroeconomic and other strengths--such as strong gross domestic product growth rates, positive political and regulatory trends, plentiful natural resources, and large populations with rapidly expanding middle classes--that make them look like dynamic places to invest and make most developed nations look like sluggish has-beens.

What's more, single-country emerging-markets funds are quite capable of posting huge gains in short period of time. For example, Market Vectors Vietnam VNM is up 41% and Market Vectors Egypt Index EGPT is up 38% for the year to date through April 26. IShares MSCI Turkey Investable Market Index TUR, iShares MSCI Philippines Investable Markets EPHE, and Global X FTSE Colombia GXG aren't far behind, with gains of between 25% and 28% thus far in 2012.

However, there's much more to single-country emerging-markets funds than the superiority of their underlying economies and their impressive upside potentials. These funds also come with serious challenges and risks. Any interested investors should make sure they carefully examine all of these issues before they purchase any of these offerings.

Enough Already?
The first thing that interested investors should do is determine how much exposure they already have to the market in question. All but one of the open-end funds and nearly three fourths of the exchange-traded funds focus on one of the following five developing countries: China, Brazil, South Korea, Russia, and India. These five countries comprise roughly 60% of the MSCI Emerging Markets Index, so they always are well represented in a variety of international-stock funds. The typical open-end diversified emerging-markets fund currently has approximately 18% of its assets in China and 56% of its assets in these five markets overall. And the average open-end foreign large-growth offering has a total of 15% of its assets in those five exchanges, while the typical open-end foreign small/mid-value fund has a total of 10% of its assets in those five markets.

Quite Concentrated and Very Volatile
Interested investors should also note that even China and other relatively large emerging markets tend to be pretty concentrated by sector and issue, so the funds that focus on them rank among the narrowest offerings around. IShares MSCI Brazil Index divides roughly 50% of its assets among the basic-materials, energy, and financials sectors and devotes nearly 60% of its assets to its top 10 names, for instance, while the average open-end Russia offering has more than half its assets in commodity-related stocks and owns just 41 names. Due to their overall concentration, as well as their political and other factors, China, Brazil, South Korea, Russia, and India funds can post huge losses in adverse conditions. Indeed, the average open-end Russia fund lost 75% of its value and the typical open-end India offering lost 64% of its value in the late 2007 to early 2009 global equity meltdown, declines even more severe than those suffered by the average open-end diversified emerging-markets fund, which lost 57% during that crisis.

The single-country emerging-markets funds that focus on the smaller exchanges are even more explosive for three reasons. First, these funds tend to be even more concentrated by sector and issue than their counterparts that are dedicated to larger developing countries. Market Vectors Vietnam has a 45% financials stake, a 25% energy position, and owns just 32 stocks, in fact, and Market Vectors Egypt Index has a 40% financial weighting, a 20% telecom-services stake, and holds only 28 names. Second, the markets these funds focus on tend to include lots of fairly illiquid names and have limited protections for foreign investors. And third, smaller emerging markets tend to come with more political and other risks than their larger peers. Market Vectors Vietnam, which invests in a one-party state with limited experience with free markets, plunged 41% and Market Vectors Egypt Index plummeted 50% in 2011's stock sell-off, in fact, while the MSCI Emerging Markets Index fell a far more modest 18%.

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