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By Jason Stipp | 01-30-2012 02:00 PM

A User's Manual for Emerging Markets

Despite a rough 2011, investors continue to put money to work in emerging markets. Here are some tips for getting your investment's worth.

Jason Stipp: I'm Jason Stipp for Morningstar. Despite a rocky performance in 2011, investors still have an appetite for emerging markets. So, how should emerging markets fit into your portfolio? Here with me to offer us a user's guide for emerging markets is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, Morningstar's Fund Flows data measure how much money people are putting into mutual funds and how much they're taking out? The data report showed that emerging-markets stocks and bonds have continued to be very popular with investors over the last year. How popular have they been?

Benz: Well, the emerging-markets bond funds took in $13 billion in 2011, and the stock funds in emerging markets took in $20 billion. So, those are pretty impressive rates of growth particularly given some of the performance difficulties especially with the stock funds. With emerging-markets bonds, I think it's important to point out the huge influx of assets as a percentage of the category's overall assets we've seen. I mentioned the $13 billion float into the category; that's about one fourth of the assets in the category overall. So we're seeing a very impressive rate of growth for both types of funds.

Stipp: Like you said, we did have hit a rough patch in 2011, and it wasn't just at the end. We actually saw emerging markets struggling throughout the year at different times. Did that slow down any of these inflows because it sounds like pretty tremendous inflows into the category?

Benz: Right, Jason. Well, the third quarter was really when we had that big global market shock, where a lot of categories fell pretty precipitously, emerging-markets stock funds included. Interestingly, in the fourth quarter, investors continue to add new dollars to emerging-markets stock funds. The rate did slow down a little bit, so that was $3 billion flowing in during the fourth quarter on a $20 billion overall asset influx in 2011, but there were still pretty impressive flows despite very weak performance there in the third quarter.

Stipp: So, we know that emerging markets on the stock side, at the end of the year, had lost about 20%. So, even though investors still put money to work in that category even after that kind of performance loss, it's not usually what we see, right? This is not how investors typically behave.

Benz: It's not. It's really an anomalous performance pattern where often we see investors retreating from hard-hit categories, adding money to those categories that have performed better. Emerging-markets stock funds have really bucked the trend here where they have continued to see investors entrust new monies to them.

All I can think, Jason, is a couple of things. First of all, if you look at longer-term performance in emerging-markets stock funds it's still quite good relative to developed-markets stocks. The other thing is that I think a lot of investors have really bought into that growth story in developing markets. They think that the rate of growth there will be much higher than they'll see in developed-markets stocks, particularly given some of the concerns that you have hobbling in Europe, some of the worries that we have here in the U.S., and some of the issues that have plagued Japan recently.

Stipp: So, certainly it's a very compelling fundamental story from the economic point of view for emerging markets. But is this a good thing that investors still are putting all of this money into emerging markets at this time?

Benz: Well, I think it comes down to a judgment on valuations really because typically valuations are the best predictor of how a market will perform. I took a quick look at the types of funds that are holding emerging markets, such as diversified funds. Interestingly, emerging markets aren't appearing to be a compelling buy to a lot of valuation-conscious managers. So, maybe foreign large-cap value managers, for example, have lower weightings in emerging markets than growth managers. So, at least when you look at what funds are holding, it doesn't appear that the value guys think that the markets are screaming by at this point even though they did have a big sell-off in 2011.

Stipp: Yes, they are at least certainly cheaper than they were about a year ago this time.

Benz: Yes.

Stipp: So that's one thing that we can say. So, if I'm looking at emerging markets, I like the story. Maybe I want a dollar-cost average in just in case there's still some room to fall here. But how do I know how much I should dedicate to emerging markets? Where do I begin, and what should I think about before I just start putting money into and emerging-markets fund?

Benz: Well, my first point would be check up on what you've got in your portfolio already. So, even if you don't have that dedicated emerging markets investment, it's a good chance that you've got some exposure through some diversified funds that you might already hold. So, as I mentioned, a lot of diversified, foreign large-cap blend, growth, and value funds have stakes in these markets. You also want to check some of your domestic funds because interestingly, when I did a quick check, I saw that some large-cap growth domestic funds had double-digit stakes in emerging markets. So when you do that checkup, don't just limit your checkup to foreign-stock funds.

In terms of setting your overall allocation, one thing I think you can use as a starting point is emerging markets as a percentage of global market capitalization. So, there emerging markets appear to be 10%-11%. Currently, I think that's a reasonable baseline when looking at whether your overall allocation is sufficient. But the other point I would make Jason, and this is something we've discussed before: This is looking at country of domicile, and that's how we currently categorize funds in terms of their geographic exposure. That's inexact because as we know, a lot of U.S. companies have big foreign operations including big emerging-markets operations. So it all is a little but murky because country of domicile really doesn't tell the whole tale about where a company is doing business and earning its revenues.

Stipp: So it's certainly very difficult to pinpoint an exact number. Maybe investors need to think about it more in a range because a lot of this is really interconnected.

So, after I kind of find a good range of where I'd like my emerging-markets stake to be and I get the investment mix together that gives me that range after all is said and done, how do I go about monitoring this? This asset class, as we've seen, has been very volatile in the past. Is there any reason to believe that we couldn't see that kind of volatility in the future? I mean the fundamentals are supposed to be better, but I wonder sometimes if people think that they are safe to the extent that they're going to be really stable, these emerging markets?

Benz: Right. I think the potential for volatility is still very much there. The potential for political instability in certain countries is still there and not worth discounting altogether. So, I think that's an important thing to keep in mind; you want to be prepared for volatility and also obviously, as you have the stomach to do so, be prepared to add to emerging markets in these periodic periods of weakness, even though valuations might not be the low. In absolute terms, it's still better to be adding when the markets are down versus when they are up. I recall something Bill Bernstein said at the Bogleheads Conference this fall. He said, he doesn't like emerging markets that much, but he likes them because periodically they get very, very cheap.

So, I think investors want to stay contrarian when they look at these markets. When you certainly look at their recent flows, that indicates that perhaps some investors are contrarian. The other thing I would keep in mind is you want to think about your age and your tolerance for that volatility as you manage your emerging-markets allocation. So, as you get close to retirement or are retired, you want to start taking risk off the table in the equity component of your portfolio. You definitely want equity exposure; you need that growth component. But you want to start reducing the volatility potential, and also your overall foreign currency exposure should be stepping down as you advance in age and as you get closer to needing that money.

Stipp: Well, Christine, it certainly sounds like emerging markets are worth a very close look for investors, but thanks for helping us invest better in this potentially volatile area of the market.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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