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By Christine Benz | 11-12-2010 04:23 PM

Where Foreign-Stock Investors Are Placing Their Bets

Fund investors have been demonstrating a lot of enthusiasm for emerging-markets stock and bond funds, but the recent stampede should give you pause, says Morningstar's Kevin McDevitt.

Benz: Hi, I'm Christine Benz for Morningstar.com.

Although investors have been yanking money from U.S. stock funds, they have been demonstrating a lot of enthusiasm for international stock funds.

Here to discuss that trend and what it means for investors is Kevin McDevitt. He is editorial director for Morningstar.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me.

Benz: So Kevin, we have got kind of this broad trend toward international stock, when you dig beneath the surface of that number where have investors been showing a preference these days?

McDevitt: Sure, there is a clear preference for diversified emerging-markets equity funds. That's almost half of those inflows. Some of them are also going to foreign large growth and foreign large value funds, but again the trend as a percentage of assets is really been towards emerging market equity funds.

Benz: Okay. So they are obviously responding to the very strong performance we have seen in those markets as well as some good fundamental news coming out of those markets. Are they sending money to some of the region-specific emerging-market funds or are they sticking mainly with the diversified ones at this point?

McDevitt: It is mostly the diversified emerging-market funds. You are seeing some going into Pacific Asia ex-Japan, but what's curious is you're actually seeing outflows out of Latin America funds, which you wouldn't necessarily expect, and then you also see flows, and this is less surprising, but flows out of Europe stock funds and out of Japan stock funds. Europe stock funds have lost roughly a third of their assets over the last year, and it's about 25% for Japan.

Benz: Okay, and performance has been relatively muted in those markets, so that could explain part of that shift?

McDevitt: Certainly, absolutely with Japan, especially, and the fears over what is happening in Europe, too.

Benz: Okay. So, I wanted to touch on another phenomenon, Kevin, which is the strong flows into emerging-markets bond funds as well as stock funds. Talk about what's going on there?

McDevitt: Sure. We've had really fantastic performance in emerging market bond funds over the last decade. In some ways, investors are just kind of waking up to that – I shouldn't say waking up – but they've become much more attuned to that over the last year, and some of that I think is due to wanting to diversify outside the U.S., diversify outside the U.S. dollar. But it is creating a response in the emerging markets themselves; you are starting to see capital controls being discussed in emerging markets and also some inflation concerns in places like China.

So there are real issues. I think investors should be aware of them and shouldn't just blindly put money into those emerging market bond funds.

Benz: So, by capital controls you mean some countries are actually imposing limits on who can buy their bonds?

McDevitt: Exactly, especially in the case of local currency bonds, you are starting to see that, because that's kind of what burned these funds or burned a lot of emerging market countries in the late '90s with the Asian credit crisis. At that time ... a lot of their bonds there had been owned by foreign investors and a lot of that money took flight during the Asian crisis itself.

So, a lot of governments have wanted to keep their local bonds owned by local investors. So I think they are reluctant to let too much money in. Unfortunately, from U.S. investors' perspective, a lot of them want that local currency exposure to diversify out of the dollar. So, there's a bit of pull and push there.

Benz: Yeah. So another area I wanted to talk about was world stock. I think this is one that you and I touched on last time we sat down for this interview. That category still seems to be losing assets. What's going on there?

McDevitt: Yeah, I think it's a couple of things. One is people wanting more pure play exposure. With any world stock fund, anywhere from perhaps 40% to 60% of those assets are in the U.S. So that's my read is that some of these just want have more of a pure play outside the U.S. and then also I think with a lot of world stock funds, you're not getting as much as emerging markets exposure.

So again if that's something you're looking for as an investor, those tend have fairly small weightings--emerging markets tend to have really small weightings in world stock funds.

Benz: Right. That makes total sense. So the fund families that have been the big beneficiaries of flows in international, can you talk about some of those?

McDevitt: Sure, and it's interesting on two levels. The two strongest fund families have been Vanguard and Dimensional Fund Advisors, DFA. Vanguard is not a surprise, perhaps. They are the largest fund company out there.

Benz: They have been getting a lot of flows period, into the ETFs as well.

McDevitt: ETFs and then in the bond fund side, certainly, they've been getting a lot of the flows there. What's interesting, though, is, a general theme that we've seen in the equity side is we're seeing a lot of interest in index funds period, and passively managed funds. You would kind of put DFA into that same group and again in fact the DFA and Vanguard are seeing the strongest flows on the international stock side. It is not surprise, perhaps, because their lineups tend to be dominated by passively managed index funds.

Benz: So, Kevin, last question, I want to talk about what investors should make of this stampede into emerging markets: Is it a contrarian indicator? I remember back in early '90s there was a similar stampede, and then a few crises later, investors really lost interest and probably didn't make much money in emerging markets. Are there alarm bells that should be going off for investors looking at these inflows right now?

McDevitt: Certainly that's a concern. We had Russ Kinnel, our colleague, just did the loved and the unloved categories [study], and the most loved equity category was, in fact, diversified emerging markets. So I think that should at least give you pause as an investor, especially if you're looking to put new money to work, it's something to be aware of, and I think, again, given the fact that you have seen great performance out of emerging markets equity funds, really since that period you're talking about--since 1998, performance has really been very fantastic. So, again, I think it's something that you want to be aware of. I can understand there is somewhat of a strategic decision and perhaps a desire to want to have exposure to those growing economies, but realize that there is a price to be paid and that valuation is a very important part of that equation, and again valuations are not as attractive today as they were perhaps five, 10 years ago, certainly.

Benz: Right. Well, sounds like good advice, Kevin. Thanks for sharing your insights.

McDevitt: Thanks Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com

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