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The Latest Trends in Emerging-Markets Funds

Flexible, broad approaches are gaining attention--from fund companies, at least.

Emerging markets have had a volatile but generally disappointing year. Their stock markets typically have risen more than those of developed markets during 2011's periodic stock surges, but have plunged further when investor worries have taken center stage. In part, the uncertainty reflects issues in individual countries, whether the potential for a slowdown in China, inflation in India, or political concerns in Brazil.

However, with growth forecasts gloomy for developed markets in Europe, the United States, and elsewhere, fund companies still look to tap into emerging markets when creating new offerings. In fact, they seem to have put extra effort into coming up with additional ways to invest in these areas.

Fund companies have introduced two innovative types of emerging-markets funds in the past few years, with the trend accelerating in 2011. Both varieties go beyond the traditional methods of investing either entirely in emerging-markets stocks or in emerging-markets bonds. In that sense, they reflect the trend toward more-flexible funds that has swept other corners of the mutual-fund universe, as well.

Balanced and Beyond
The balanced-fund concept is a venerable one. With a 60/40 or 50/50 split between stocks and bonds, the aim is to moderate the volatility of the equity stake with the steadier performance of the fixed-income sleeve. Or, looked at the other way, the goal is to add the growth potential of stocks to the more-muted expectations of bonds. Over time, different permutations of this idea arose, but only in recent years has a group of funds arrived that takes the stock/bond combination to the emerging-markets realm.

The idea of a balanced emerging-markets offering isn't completely new, though. A closed-end fund, Templeton Emerging Markets Appreciation, used such an approach in the 1990s before merging into Templeton Developing Markets (TEDMX), a pure-stock fund, in 2002. But now Templeton is back in the game with Templeton Emerging Markets Balanced (no ticker yet). And it's not alone. In the past 12 months, several other funds that invest in a mix of emerging-markets stocks and bonds have been launched. These include Lazard Emerging Markets Multi-Strategy , AllianceBernstein Emerging Markets Multi Asset (ABAEX), Dreyfus Total Emerging Markets , and PIMCO Emerging Multi-Asset . 

As their names imply, some of these funds offer more than straightforward, static combinations of stocks and bonds. Currency moves play a large role at some, for example, while others can make dramatic asset-allocation calls. Still, stocks and bonds are likely to be the cornerstones of these portfolios over time. The PIMCO fund's benchmark, for example, is a combination of 50% emerging-markets equities and 50% emerging-markets debt, with the latter split equally between issues denominated in local currency and those denominated in U.S. dollars or another major currency.

Geographically Open-Minded
Balanced funds aren't the only notable trend in emerging-markets fund launches. Fund companies also have opened a handful of offerings that strive to take advantage of the rapid growth rates of emerging markets while taking a broader geographic view than traditional emerging-markets portfolios do. Unlike balanced or multiasset funds, these funds focus completely, or mostly, on equities. However, in addition to owning firms located in emerging markets, they also invest substantial portions of their assets in the equities of companies that are based in developed markets but have considerable business in emerging markets.

The theory is that these wider-ranging portfolios will be less volatile than typical emerging-markets stock funds. The creators of these funds expect the stock prices of developed-markets companies to hold up better than those of emerging-markets firms when panic strikes and many investors reduce their exposure to emerging markets by dumping the stocks of companies headquartered there.

As with balanced emerging-markets funds, this idea isn't completely new. American Funds New World (NEWFX) has taken this approach since its 1999 inception (though it does own some bonds, as well). It has provided the performance one might expect: The fund has beaten pure emerging-markets-stock funds when stock markets have fallen, and lagged when rallies are on. Now there are more contenders in that arena. Calamos Evolving World Growth (CNWGX) has substantial exposure to developed-markets issues, recently amounting to about half of assets according to its website, and it includes convertibles in the mix. Thornburg Developing World (THDAX), meanwhile, is taking a similar approach but with a smaller stake in developed markets.

What Will The Future Hold?
Both of these approaches have merit. The idea behind balanced funds--that bonds undergo more-modest performance swings than stocks do, while providing some income--applies in emerging markets as it does in developed ones. The performance of the funds in Morningstar's diversified emerging-markets (that is, all-stock) and emerging-markets-bond categories in the past 10 year demonstrates this. In fact, the pattern held true every year.

For example, in both 2001 and 2002 the emerging-markets bond category average posted double-digit gains while the stock group sat in negative territory. Conversely, from 2005-07, the diversified emerging-markets category posted robust gains of between 30% and 40% each year, while the emerging-markets bond group had more-muted returns of between 5% and 12% per annum. This year's contrast truly grabs one's attention: Through Nov. 4, the diversified emerging-markets stock category has lost 13.7%, but the emerging-markets bond group is up 3.7%.

Meanwhile, American Funds New World has shown that the approach focusing primarily on equities can accomplish its goals, as well. And it's worth noting that these two approaches are not mutually exclusive. As noted, the New World fund owns some debt; and Lazard Emerging Markets Multi-Strategy has meaningful exposure to developed markets. It wouldn't be surprising to see even more wide-ranging emerging-markets funds arrive in the next few years.

However, it's still an open question whether these types of funds are worth owning. Individuals can easily build their own combinations of emerging-markets stock and emerging-markets bond funds. In addition, many foreign large-cap funds have been investing more heavily both in emerging markets and in developed-markets companies with strong emerging-markets exposure. U.S.-focused large-cap funds also tend to own plenty of companies heavily exposed to emerging markets.

In any case, it's much too early to assess the new funds. Few have gathered many assets as yet. Their lack of track records adds another reason for caution. Investors who do want to buy must carefully assess a fund's specific strategy, its management, and its cost before jumping in.

It's worth keeping tabs on these funds and the others sure to follow, though. Such innovative, flexible approaches could be a fad that will eventually run its course--or could become the dominant way to invest in emerging markets in the future.

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