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Market Update

For Better or Worse?

Investors demonstrated a persistent affinity for emerging markets despite a tough year for EM-focused funds in 2011.

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Investors were likely glad to see 2011 hit the history books, especially those who were positioned heavily in the emerging markets--and that's not a small group, even in spite of the regions' poor performance during the year.

How bad was it? Chinese equities were hammered in 2011, losing over 21%, while Brazil's main index was down 18%. Indian equities also had one of their worst years ever, as the country's benchmark 30-share Sensex plunged 23%.

Despite this, emerging-market funds (those belonging to the Morningstar Diversified Emerging Markets category) received their second-highest investments ever in a calendar year, at $20 billion (as of November end). That figure is second only to the $28.5 billion that emerging-markets mutual funds attracted in all of 2010.

It's been a surprising development to see investors move so much money into an asset class that has not only suffered but is also generally known to be highly volatile. A quick glance at some performance stats during this trying time reveals that all 165 U.S.-based funds that invested in emerging markets logged negative returns, with some losses as high as 30% or more. In comparison, the MSCI Emerging Markets Index closed the year down about 20%.

Of the 10 largest funds by assets, three trailed the MSCI Emerging Markets Index in 2011, while five other funds performed only a little better. The worst performer of the group was  DFA Emerging Markets Value I (DFEVX), which logged returns of negative 25.6%, trailing the MSCI Emerging Markets by about 6 percentage points. Of the top 10 largest funds, it also received the most flows, at $4.2 billion.

The fund's underperformance may have been the result of a mild bias toward China (it had a 13.36% weight toward China in August compared with the category average of 12.05%). Throughout the year, the fund remained about a percent or more overweight on China compared with the category average. It also missed the rally in Brazil when the country's apex bank opted to cut interest rates (in August), sending equities in a northerly direction. The fund was among those underweight on Brazil, with a weighting of 12.2% compared with the category average of 16.39%.

In comparison,  Aberdeen Emerging Markets Institutional (ABEMX) emerged with the best record among the 10 largest funds, beating the MSCI Emerging Markets Index as it logged a return of negative 11%. Unlike the group's worst performer, Aberdeen was among those most heavily weighted toward Brazil throughout the year. It was also among the most underweight on China, which helped to protect it on the downside.

Interestingly, one fund that did better than nearly all other emerging-markets funds in 2011 was  Invesco Developing Markets (GTDDX). It had much more invested in the smaller Asian markets--the Philippines, Malaysia, Indonesia, Thailand--than other funds did, and those markets held up much better than China and India. The fund had nothing in India and a little less than the standard category weighting in China. It also had a higher-than-average weighting in Mexico. Mexico was among the best-performing countries, as its benchmark BMV IPC index logged a negative return of just 3.82%.

But even the top-performing funds in the category lost money in 2011, so why were so many investors continuing to bet on the emerging markets? Was the growth story oversold?

It may seem so considering the continuing fancy that investors took to these markets. But some fund managers don't agree.

Mirae Asset Global Investment's chief investment officer Gopal Agrawal believes that the long-term positive structural growth prospects that emerging markets enjoy in comparison to developed markets still hold true.

According to Agrawal, "EM's don't have debt problems, an aging population, entitlement issues, etc. The underperformance witnessed by emerging markets in 2011 was as a result of rising inflation and differing monetary policies by central bankers."

Nevertheless, the first weeks of 2012 saw a flight of capital from the emerging markets back to the U.S. During January, U.S. mutual funds attracted the most weekly inflows in almost two years, as investors' poured cash into bond funds and some stock funds. Funds had net deposits of $11.3 billion in the week ended Jan. 11, according to the Investment Company Institute. Stock funds had seen record outflows of about $78 billion in the last year, although the stock markets ended almost flat.

Morningstar's editorial director of fund research Gregg Wolper explains, "Traditionally, when types of funds lag and especially if they lose money for shareholders for an extended period, they do tend to have outflows."

Lower interest rates and supportive monetary policies may also favor developed markets more than emerging markets in the short term.

While fears of an economic slowdown in China have led many managers to reduce their weightings there, Agrawal says the scenario of a hard (or soft) landing is unlikely, given the recent data on the major consumption points.

Rouhan Sharma does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.