Buying the Year's Hottest Performers

Investors really can't be blamed for taking a second look at a fund category that has gained 116% this year.

116%--you read that right. That's the return of the Latin America fund category year to date. (For more details, see senior fund analyst Gregg Wolper's recent Fund Spy article, "An Inside Look at 2009's Best-Performing Fund Category".) Of course, Latin America is just one hot subgroup that falls under the broader umbrella of emerging-markets funds. Other categories in this group that are serving up mouth-watering returns are the diversified emerging-markets category and the Pacific/Asia ex-Japan stock category, each up more than 70% this year through Dec. 4, 2009.

Will Emerging Markets Continue to Rally?
We're hearing arguments on both sides of the fence--some say that emerging markets are looking overvalued after this year's steep runup, and others say that there is plenty of room to run.

Certainly Dubai's recent debt crisis gave a brief reminder of the perils of investing in risky asset classes. When investors are especially wary of risks in the form of leverage, uncertain corporate governance, and potential political instability, emerging markets will take a hit as money shifts toward more defensive asset classes.

Nonetheless, there is definitely a case to be made for investing in emerging-markets securities for the long term. They offer diversification for a U.S.-centric portfolio as well as very strong long-term capital appreciation potential. Many of those who specialize in the area believe that the fundamentals are strong and that developing-market countries offer compelling valuations and excellent prospects.

For example, Gonzalo Pangaro, who runs  T. Rowe Price Emerging Markets Stock (PRMSX),  is sanguine about the prospects, saying that many developing markets appear "well positioned amid the global economic recession," which Pangaro believes will feature strong demand for infrastructure spending in materials, industrials, technology, and natural resources--areas that many emerging-markets countries have in spades.

For investors who decide they want to add some emerging-markets exposure to their portfolio, choose carefully. Don't just pick the best performers; consider the more conservative funds in the category and pay particular attention to how funds have held up during the sell-offs, such as 2008 and early 2009.

Keep diversification in mind as well. Investors have tended to get very excited over the sometimes spectacular returns produced by narrower mandates, but during a sell-off, regional and single-country funds can take the biggest hits because of their market risk and sector concentration. (For instance, the  iShares MSCI Brazil Index ETF (EWZ), which is up 124% this year, would fall hard if the tide turned against the energy or industrial materials sectors, where over 90% of its assets are concentrated.) Geographic breadth and a diverse mix of stocks will serve you well over the long run in terms of reducing volatility--at least as much as one can in this area.

When Should You Invest?
Buying into any asset class after a period of strong returns can be dicey. You could be buying in at exactly the wrong time--plunking down a pile of your hard-earned cash into a fund only to see performance fall off a cliff. Imagine, for instance, that you invested in T. Rowe Price Emerging Markets Stock in January 2008 after it had gained nearly 40% per year from January 2003 to December 2007. You would have put your money in just in time to see it lose more than 60% during calendar-year 2008. Yikes.

On the other hand, you might have been the investor who put money in at the end of 2002 and watched your investment chalk up dazzling gains for five straight years. Now, the fund is up more than 85% so far in 2009. Is this the beginning of another multiyear rally, or a quick bounce before a swan dive?

The truth is, it's impossible to know. If you could accurately predict which scenario would come to pass, you would know exactly how to invest. But because market-timing this asset class is notoriously difficult, dollar-cost averaging, or investing fixed dollar amounts into an investment over time, is a wise move. By dollar-cost averaging, you won't miss out on good growth if the rally continues because you will have some exposure, but you won't get crushed if emerging markets sell off quickly, because you didn't put all your money on the table.

Perhaps the most important advice is to have realistic expectations. Don't assume you will double your money over the next nine months.

Before You Invest--Take Stock!
Before you embark on your dollar-cost averaging adventure, take stock of your portfolio and see how much exposure to emerging-markets assets you already have. You may have plenty even if you don't own an emerging-markets fund. Many broad international funds have substantial emerging-markets stakes within their portfolios, for example.

It doesn't end there. Look at your current allocations, especially in light of recent performance, and you might be surprised, said senior mutual fund analyst Bill Rocco. "Don't forget to check all your equity funds. The typical U.S. stock fund has 8% in international. Some of these funds have stakes in emerging markets. People need to look at the whole picture. You probably have about 10% [emerging-markets exposure] in your foreign large-cap fund."

One place unlikely to have much of an emerging-markets stake is the target-date arena. Even the more aggressive target retirement funds, geared to investors currently in their 20s and early 30s, have less than a 5% allocation to emerging markets.

A useful tool on Morningstar.com is Instant X-Ray, which allows you to quickly and easily size up your portfolio's diversification. To use it, enter the ticker symbols and dollar amounts or percentages for each of your holdings (which can include both funds and individual stocks), and then click Show Instant X-Ray. You can save your portfolio to Morningstar.com's Portfolio Manager for future reference, which makes monitoring your allocations easy.

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