Are You Getting In on the Emerging-Markets Action?

The rally in emerging markets just won't quit. Sure, there have been a few alarming declines along the way--most recently just two months ago--but they didn't last long. For the overwhelming majority of the time, indexes in emerging markets have been on a tear since 2003. The exception is China. Its rally began much later than most--in late 2005--and accelerated much more rapidly. This year alone, Chinese stocks have risen by triple digits.

The astonishing numbers racked up by emerging-markets funds attract attention. Even if you're not the type who typically dives into the latest hot trends, it's hard to avoid wondering if you've missed the boat this time. Others, who know that they have indeed taken part in the great gains, might be wondering the converse: Is it time to get out so I can hang on to what I've gained?

China: Making Up for Lost Time
It would be wrong to lump all emerging markets together when one of them stands out to such a degree, both in terms of performance and in the frequency of exuberant headlines. The list of funds with the top one-year returns through Oct. 11, 2007, teems with China funds. Several boast returns of 100% or more; two have zoomed past the 150% mark. Meanwhile, anyone who keeps up with the news can't help but see stories about China's explosive growth rate and the likelihood that it'll stay that way a long time.

If you own a China fund, then you know you have exposure there. What type of exposure, though, is a complex question: It's more complicated to determine what qualifies as a "China stock" than you might think. So the figure for a fund's "China stake," on its own, can tell you only so much. Bill Rocco rendered these complexities understandable in a May Fund Spy column. But it's important to know that even investors without a fund specifically targeting China--the overwhelming majority of people--in all likelihood do not lack exposure to that country's growth or, in some cases, to the stocks themselves.

Most directly, many broader emerging-markets funds own Chinese stocks in greater or lesser amounts. Nearly all Asia ex-Japan funds do--that's one reason  T. Rowe Price New Asia (PRASX) and  Fidelity Southeast Asia (FSEAX) join the China-specific funds on that 100%+ list. But even funds that invest more broadly, in emerging markets around the world, typically own some China stocks. Then there's the next level--even broader international funds, the most common variety. Many of those also own a few China stocks. (Last week's column by David Kathman explains that even some U.S.-focused funds have substantial stakes in China stocks.)

More critically, even if funds don't directly own China stocks, they still can be profiting from China's extraordinary growth rates. For example, many managers have told us they've owned Brazilian iron-ore giant CVRD specifically because it benefits directly from China's huge appetite for that commodity. James Moffett of  UMB Scout International  and David Herro of Oakmark International (OAKIX) are among the managers who avoid China stocks because of concerns about the legal system, quality of the companies, valuations, or other factors, but whose shareholders still benefit from many stocks in the portfolios that take advantage of China's growth.

Less Focused, Still Potent
Although the extraordinary gains made by China's stocks capture the most attention, the story of stocks fueled by high growth rates and the demand caused by expanding middle classes is actually a broader emerging-markets story. For example, check out the remarkable ascent of India's stock market in recent years. And Brazil's market has zoomed. Here again, it's important to recognize that even if you don't own a fund that specifically targets emerging markets, it's very likely you still have exposure to those rapidly growing economies.

As with China itself, there are two ways that happens. One is direct exposure. Most international funds have owned stakes in emerging markets for years--around 8% or 10% for a large-cap fund is the norm. The managers don't even have to be very adventurous to get there--own some shares in CVRD and a couple of generic-drug giants and that alone could get a fund over the 5% mark. And a fund doesn't have to be one that's considered aggressive, either, to take this tack. Dodge & Cox, for example, is certainly not known as a daring risk-taker, but  Dodge & Cox International (DODFX) has 17% of its assets in emerging markets. One of the managers, Diana Strandberg, says the growth rates in those markets are so impressive one has to favor them as long as one can find a great company at a compelling valuation there.

But Strandberg doesn't stop there. She also emphasizes that her fund's 17% figure doesn't fully capture the fund's exposure to emerging-markets growth. Even many of the companies in the portfolio from Western Europe or Japan, she says, were bought specifically because they do so much of their business in emerging markets. She mentions U.K. bank Standard Chartered as one example and  Honda Motors (HMC) as another.

And as with China alone, many U.S.-based companies also count much of their growth potential from sales in emerging markets in general, so even investors with no international fund per se probably aren't being shut out of that portion of the world. In a recent Fund Spy column, Michael Breen demonstrated how a surprising amount of the revenue of leading U.S.-based companies comes from abroad. He didn't break out the emerging-markets portion of that, but it would be hard to imagine that figure would be negligible.

The Juice Box Springs a Leak
The bottom line is that there are many, many ways to get exposure to the growth, both current and potential in China, specifically, and in other emerging markets. Even if you lack a fund with a specific emerging-markets label, if you have a diversified portfolio you probably have a significant amount of exposure, in various ways and at various levels. Before adding to the most direct kind of exposure, keep in mind that that stake won't always have a positive impact. After some future downturn, the markets won't immediately snap back. When that reversal strikes, those funds that have the most direct focus will suffer the deepest losses, just as they've enjoyed the juiciest returns during the long, long upswing.