Are You Panicking Over the Emerging-Markets Slide?

"Fears Over Interest Rates Send Emerging Markets Tumbling"
"Dealing on Indian Exchange Suspended"
"Worst Emerging Markets Run Since Russian Default"

These alarming reports, which appeared in the May 23 editions of The Wall Street Journal and Financial Times, indicate the depth of the slide in emerging markets around the world. And while those items referred to a single day's carnage, the decline has been going on for weeks now. As a result, after several years of stupendous gains, suddenly emerging-markets funds are showing some serious short-term losses.

It's rarely worthwhile to try to draw deep conclusions from such a brief period. And it's true that the United States and other developed markets were also falling. But emerging markets were taking the biggest hits by far. So this episode does provide an opportunity for reflection and offers a chance to answer some questions. For example, given the structure of certain emerging-markets funds, are they reacting during a sharp sell-off as one would expect? Separately, how are you yourself responding--and what does that mean for your investment decisions? For the first time in awhile we've got a chance to check up on these matters.

Looking in the Mirror
Let's start with the latter question--how you've reacted to the slide in emerging markets. If you find that you're shocked or overly nervous in response to the sharp losses either in emerging-markets funds you own or in those markets in general, now's a good time to reassess whether you should own such funds in the first place.

After all, in the wake of three years of fabulous gains, the chance of a stumble was strong. Even without such a powerful rally, the threat of painful losses in emerging markets is always present. That's true even though some companies in emerging markets--Korea's Samsung and Brazil's Embraer are just two examples--have become global leaders in their fields and many of the overall markets are not nearly as raw or untested as they were in previous decades. One reason these markets contain such dangers is that they still tend to attract a great deal of "hot" money when they're rising--meaning money from international investors who are looking for the latest, best short- or mid-range opportunity and who are ready and willing to exit quickly when the tide turns.

So far, this current slide is mild both in amount and duration relative to other emerging-markets drops. Therefore, if you're spooked by this, consider how you'll feel if the markets plunge much further--over the span of, say, two years. The average Pacific/Asia emerging-markets fund lost 30% in 1997--and then lost another 5% the next year. Lengthy stretches in 1994-1995 and 2000-2001 also featured staggering losses in emerging markets. If you aren't convinced you'll hold on through that, or if the prospect of such an episode is too unsettling even to contemplate, stick to broader international funds that have emerging-markets exposure but maintain the overwhelming percentage of their holdings in Western Europe, Japan, Australia, and Canada. If you're particularly keen on emerging markets, you can find broad international offerings that have significant stakes in such areas without overdosing on them.

Looking at the Funds
If you decide you specifically want to own a fund dedicated to emerging markets, strongly consider one that invests in all or most of them rather than a fund that puts the lion's share of assets in a single market or small region. Sure, you can hit it big by taking the narrow route: If you owned a Russia fund for the past five years, you've been in the money big time. An India fund also would have made you very happy indeed. But unless you've got exceptional powers of prediction, it's very tough to know which country to choose. And single-country funds are more susceptible to deep short-term losses than a broader emerging-markets fund. At least that's the theory. Did that prove true during the current decline?

Yes, it did. An exchange-traded fund, iShares MSCI Brazil Index (EWZ) has plunged 18% over the past month through May 23, while iShares MSCI South Africa Index is down 15.4% and Third Millennium Russia  has fallen 13% even after gaining back 4.3% on May 23 itself. By contrast, broader-based offerings are showing milder losses. For example,  Vanguard Emerging Markets Stock Index (VEIEX) is down 9.5%, and  Templeton Developing Markets (TEDMX), one of the oldest and biggest actively managed diversified emerging-markets funds, has lost 9.1%.

Meanwhile, it's worth checking up on another prominent offering,  American Funds New World (NEWFX), to see if it has held up better than most during this downturn. We have every right to expect it would: After all, the fund lagged by a long shot during the long emerging-markets rally, no doubt disappointing some shareholders who weren't completely aware of its structure. Although it targets emerging markets, it doesn't focus exclusively on them; instead, it devotes a substantial portion of assets to multinational companies in the United States and other major developed markets. It also has held significant cash stakes in the past couple of years. As a trade-off for those relatively moderate gains during rallies, the fund needs to provide a cushion during sell-offs. And it did come through: American Funds New World declined just 7.1% over the trailing one-month period, one of the mildest losses posted by any diversified emerging-markets fund.

A Final Thought
Just to be clear, we're not suggesting you must stay away from emerging markets. In fact, many of the best international managers see excellent long-term opportunities available in such areas. The key is to make sure you understand the risks and to be cautious when deciding how you want to approach this realm.