Stay Away from This Emerging-Markets Play

When you buy an emerging-markets fund, you take on extra risk. Although there are plenty of stable, solid companies available in emerging markets, and the governments of many such countries have improved their financial management over their years, the currencies of those countries are still more vulnerable to swings, and they harbor a greater amount of political risk. For example, government instability or sharp policy shifts can play havoc with currencies and stock markets alike.

True, the recent coup in Thailand and the current political turmoil in Mexico have not led to plunging markets or currencies in those countries. At least, not so far. But those events do serve as timely reminders of the risks found in emerging markets that you don't find in, say, Switzerland.

With that in mind, adding even more risk to the equation is a questionable move to make. But some people do just that. Instead of buying a broadly diversified emerging-markets fund--one that can invest all over the developing world--they'll buy one that invests in just one region or one country. If trouble hits that region or country, such funds can't shift their assets to more stable areas.

What may surprise you is that there's yet another layer of risk one can add: buying an emerging-markets closed-end fund at a huge premium. The problem there is that you can get the story right and still lose out. In other words, even if the fund's holdings rally as shareholders hope, that extra risk factor--the premium peril--can sabotage shareholder returns.

When the stunning growth rates of specific countries or regions become the fodder of magazine cover stories and TV profiles, you might be tempted to try to cash in by jumping into such a fund even at a steep premium. Resist the temptation.

Enter the Dragon
When you're buying a conventional mutual fund, you buy it at its net asset value, or NAV. (A sales charge may be added for a broker-sold fund.) A closed-end fund is structured differently; after raising its initial asset base, it closes. Shares can then be bought only from existing shareholders on an exchange, as with a stock. As a result, its price is almost always higher or lower than its NAV--meaning it's selling at a premium or a discount, respectively.

The problem with buying at a premium is that the premium can contract--a 20% premium can become a 10% premium, or even slide to a discount--even as the fund's underlying holdings, and thus its NAV, are rocketing ahead. And then you, the shareholder, won't get the full amount of that NAV gain. In the worst case, you won't get any gain at all, despite a rally in the stock market you've targeted. The problem can occur even when a fund sells at a modest premium, which could turn into a discount, or sells at a small discount, which could fall to a deeper discount. But the risk is enhanced when you initially buy at a hefty premium that, history shows, is unlikely to be sustained.

This isn't just theory. The process has hurt actual shareholders in recent years. Perhaps the most notable example is China Fund (CHN). In 2004, even though China-related stocks didn't perform nearly as well as those in other emerging markets, the securities in this fund's portfolio did eke out a 1% gain. But that was in NAV terms. On a market-price basis--what shareholders actually received--the fund suffered a painful 11% loss. That's because the premium contracted as the fund's shares traded at lower prices. The next year things improved in NAV terms--but became much worse for shareholders. The fund's NAV return in 2005 was 5%, but, remarkably, shareholders got stuck with a 22% loss, as the premium kept shrinking.

Then came 2006. Finally, China's market started rising strongly, and investors who had bet on that rise by buying China Fund--or who had added to their previous holdings in the hope that the situation would finally shift in their favor--enjoyed a 24% total return on their shares (on a market-price basis) through August. Unfortunately for them, they still came out on the short end: The fund rose 28% in NAV terms.

How could this happen over and over? Simple. In 2003, Chinese stocks were on fire and the fund gained 83% in NAV terms. Investors snapped up fund shares, more than doubling the price of the shares. This pushed the fund's premium above 50% at one point. (By comparison, a 15% or 20% premium is typically viewed as quite steep in the closed-end arena.) That premium has been declining more or less steadily ever since. Now the fund trades at a slight discount to its NAV.

Beyond the Great Wall
Unfortunately, the China Fund experience is far from unique. In the latter half of 2003, the shares of Indonesia Fund , which had been trading at a discount earlier in the year, also skyrocketed as the Indonesian market's soaring stocks attracted international attention. That pushed the fund's share price to a 23% premium over NAV. The rally in Indonesia's market continued the next year, and the fund gained 32% in NAV terms--but shareholders had to make do with a meager 9% return on a market-price basis. The market-price return lagged the NAV return by a substantial margin again in 2005. Fortunately for those hardy shareholders who held on through those disappointments, that situation finally reversed this year.

Similarly, Templeton Russia and East European  had a premium higher than 40% just a few months ago. That premium has shrunk to less than 20%. And that premium could continue to decline, or even disappear: In fact, just a few years ago the fund commonly traded at a discount. The problem isn't restricted to single-country or regional funds, either. Templeton Emerging Markets (EMF), which invests in developing countries all over the world, had an 11% year-to-date return through August in NAV terms, but on a market-price basis it had suffered a 3% loss.

What to Do?
Fortunately, you have plenty of alternatives when considering an emerging-markets play. You could buy an exchange-traded fund; because of their structure, those have minimal premiums and discounts, if any. Or choose a conventional open-end mutual fund. You could even pick a closed-end fund that happens to be trading at a historically deep discount. And of course you could decide against adding emerging-markets exposure through a specific fund, instead leaving that decision up to the manager of a broad international fund you already own.

Whichever course you choose, remember this: When you see a closed-end emerging-markets fund trading at a huge premium, run the other way.