Risk-Conscious Ways to Make Emerging-Markets Plays

Developing countries have enjoyed quite positive economic and demographic trends during the 2000s. Governmental policies and corporate practices have also improved considerably in many emerging markets the past decade. Equity funds that focus on the developing world have capitalized on these favorable conditions. The average diversified emerging-markets fund has earned a 10% annualized gain over the past 10 years, while the typical foreign large-blend, foreign large-growth, and foreign large-value offerings have posted 0.0%, 0.3%, and 2.3% annualized returns, respectively.

Most experts say the economic, demographic, government, and corporate conditions in the developing world will continue to improve for years to come. There are ample grounds, therefore, to be hopeful that diversified emerging-markets funds will produce good returns and outpace foreign large-cap offerings over the long run. (Diversified emerging-markets funds are unlikely to beat foreign large cap by as much over the next decade as they have over the last one, though, as the 2000s were exceptionally poor for most developed-markets stocks.)

All this makes diversified emerging-markets funds enticing, but such funds come with real risks. In fact, they have had a more tumultuous ride than most other categories of funds in 2010--and they were slightly in the red for the year to date through July 16--because worries about inflation in China and Brazil and other concerns have hurt stocks in those two and many other developing nations. Meanwhile, the rough spells have been more severe and somewhat common in the past. These funds lost nearly two thirds of their value in the late 2007 to early 2009 worldwide sell-off, due to anxiety about a global recession and apprehension about valuations and local challenges in many developing nations. And they've been much more volatile over time than all categories of international-stock offerings, except regional emerging-markets funds.

But investors who'd prefer to take on somewhat less risk while making a long-term play on the positive conditions in the developing world do have some good options. They fall into three camps: emerging-markets stock funds with strict stock-selection disciplines, emerging-markets stock offerings that take open-minded approaches to the asset class, and emerging-markets bond funds.

The Strategy Does the Trick Here
The funds in the diversified emerging-markets category are no different from those in most other equity groups in that they employ a wide range of stock-selection styles. Those at the bold end of the spectrum in this category tend to do things like pay up for issues, favor hot sectors and countries, and run a concentrated portfolio of names, while those at the tame end of the spectrum tend to pay considerable attention to valuations, go light on trendy industries and nations, and spread their portfolios across a considerable number of names.

 Dreyfus Emerging Markets  stands out among the funds with conservative stock-selection styles. Manager Kirk Henry won't consider a stock unless it is trading at a sizable discount to its home market and global competitors and it has a catalyst for improvement, as well as good long-term prospects. What's more, he promptly sells holdings once he thinks they're fully valued; he's quite comfortable with modest weightings in trendy areas; and he owns more names--and invests fewer assets to his top 10 holdings--than most of his peers. Henry has put these temperate traits to effective use: This fund has held up much better than most of its peers in downturns and has been significantly less volatile than its average rival over time. And thanks to his stock-selection skill, it has earned superior long-term returns.

Flexibility Moderates Risk in This Case
While Dreyfus Emerging Markets and the vast majority of other funds in the diversified emerging-markets category focus on the stocks of companies domiciled in the developing world, a few funds in the group take a more expansive view of the asset class.  American Funds New World (NEWFX) is the most prominent and attractive of these more-flexible offerings. Its managers invest in emerging-markets stocks and bonds, as well as the equities of firms that are headquartered in the developed world but have significant ties to the developing world.

Emerging-markets bonds and developed stocks, which normally make up 30%-50% of assets, are far less explosive than emerging-markets stocks, and the managers employ a sensible approach to security selection and spread the portfolio pretty evenly across hundreds of issues. Not surprisingly, American Funds New World has held up much better than most of its rivals in sell-offs and has been the least-volatile member of its category over the long run by far. And though its conservative style has certainly been a burden in emerging-markets rallies, its longer-term returns are in line with the group averages.

There are two young funds that use similarly malleable approaches. The managers of Calamos Evolving World Growth (CNWGX) employ a high-quality growth discipline and readily consider developed-world firms with ties to emerging economies, as well as companies based in developing countries. Unlike most peers, they invest in a mix of stocks and convertible securities. The managers have had lots of success investing in equities and convertibles from around the world at other Calamos offerings, and this fund has posted superior results since opening in mid-2008, by shining in rough periods and holding its own in rallies. Lewis Kaufman of seven-month-old Thornburg Developing World (THDAX) has a comparably broad equity universe, and he has the leeway to buy emerging-markets bonds, although he has yet to do so. He utilizes the same eclectic stock-selection strategy as other Thornburg managers have used to post terrific results. Neither of these funds is a proven winner yet, of course, but they both have potential.

The Asset Class Sets the Tone for These Funds
Emerging-markets bond funds are starting to get more attention. They received $11.5 billion in inflows during the 12 months ended June 30, 2010, and now have around $28 billion in assets. But diversified emerging-markets equity funds garnered considerably more inflows during the period and now have approximately $144 billion in assets.

This disparity is puzzling. Emerging-markets bond funds, which generally invest in both sovereign and corporate credits, are also direct beneficiaries of the strong economic climates, favorable demographic changes, sound government policies, and improved corporate environments in the developing world, and they've taken ample advantage of that fact. In fact, they've posted an 11% annualized return during the past 10 years. That's better than the 10% annualized return posted by diversified emerging-markets funds. And because bonds are much less risky than stocks, emerging-markets bond funds have been far less volatile than their equity counterparts over time.

There are a number of attractive emerging-markets bonds funds, but three of them are especially fetching:  Fidelity New Markets Income (FNMIX),  PIMCO Emerging Markets Bond , and  PIMCO Emerging Local Bond . John Carlson uses a moderate and sound strategy at the Fidelity fund, and he has executed it skillfully in a variety of climates, so the fund boasts a good long-term record. PIMCO Emerging Markets Bond has an impressive management team, a measured valuation-conscious style that focuses on dollar-denominated issues, and a long history of success going for it. PIMCO Emerging Local Bond is bolder than its sibling, because it favors local-currency credits, which are more volatile than dollar-denominated issues. But it takes a high-quality approach to security selection, has gotten off to a strong start, and also is in exceptional hands.

Conclusion
These funds are good sources of exposure to the developing world, and they take on significantly less risk than the typical diversified emerging-markets offering. But they're certainly not without significant risks or tame offerings in the absolute sense. Indeed, though both Dreyfus Emerging Markets and American Funds New World suffered some of the smallest losses in the diversified emerging-markets category in the late 2007 to early 2009 meltdown, they both shed more than half their value in that period. And while Fidelity New Markets Income, PIMCO Emerging Markets Bond, and PIMCO Emerging Local Bond have suffered fairly average volatility for emerging-markets bond funds, they--like all such offerings--have had some real rough spells and have been much volatile over time than most other types of fixed-income funds. Thus, these funds do require tolerances for tough times and long time horizons.