Attention Emerging-Markets Stock-Fund Shoppers

An otherwise good year for equities hasn't been so rosy for emerging-markets stocks. Led by fears of slowing economic growth in China, but also dragged down by lackluster returns in India and Latin America, emerging-markets stock funds have been among the few equity losers of 2013. As of July 29, the diversified emerging-markets stock category had lost 6% year to date. Meanwhile, China-region funds had dropped 2%, with the India and Latin America equity-fund categories each losing about 15%.

Despite a rough first half of 2013, diversified emerging-markets stock funds were up about 5% during the 12-month period leading up to July 29--nothing to write home about, but not horrible. But with the S&P 500 up 24% during that time, emerging-markets stock funds--which tend to be more volatile than their developed-markets counterparts--look like laggards by comparison. It's the continuation of a story that's been going on for a few years now, with the category modestly outperforming the index in 2010 and 2012 but experiencing steep losses in 2011, producing a three-year annualized return of a measly 1.2%. (Morningstar's John Rekenthaler notes in this recent column that despite the lackluster performance of emerging-markets stocks, investors have poured $140 billion into traditional mutual funds and ETFs investing in them during the past three years.)

Of course, emerging-markets stocks are unlikely to underperform forever. In fact, GMO's recently released seven-year market forecast sees emerging-markets stocks as the top-performing asset class during that time frame, with 7% annualized returns after inflation compared with negative 1.2% for U.S. large-cap stocks and 3% for international large caps. (For a peek at GMO's seven-year forecast for various asset classes, see the chart toward the bottom of this page.)

Whatever one's personal feelings are about how emerging-markets will perform in the coming years, their recent poor performance--and the strong returns of U.S. equities--means that some investors may now find their portfolios have become underweight in emerging markets, making this as good a time as any to rebalance. As a benchmark, consider that the  Vanguard Total World Stock Index ETF (VT), which tracks most of the world's publicly traded stocks, allocates 9.5% of its portfolio to emerging markets. (To share your own emerging-markets strategy in Morningstar.com's Discuss forum, click here.)

Those looking to add emerging-markets equity exposure, or just looking for a better fund than the one they already own, have several quality offerings from which to choose. Morningstar Premium Members can click  here to see a list of diversified emerging-markets funds with Morningstar Analyst Ratings of Gold, Silver, or Bronze, meaning they have been vetted by our experts and are expected to outperform their benchmarks or peer groups on a risk-adjusted basis over the long term. Our list, compiled using Morningstar's  Premium Fund Screener tool, includes only noninstitutional funds currently open to new investors. Some load funds are included, but users who prefer no-load funds can add that filter to the screen. Described below are three funds from the list.

 Vanguard Emerging Markets Stock Index (VEIEX)      
 |  Analyst Rating: Silver |  Year-to-Date Performance: -9.4%     
For investors who prefer an index-based approach to emerging markets, this low-cost fund fills the bill. It tracks the FTSE Emerging Index, a cap-weighted index of about 750 securities from 22 emerging markets, with the largest allocations to China, Brazil, and Taiwan. One issue to be aware of is that the fund recently switched its benchmark to one that does not include South Korea, as the previous benchmark did, because it considers it to be a developed market. The fund does not hedge currency exposure, meaning that a rising dollar could cause its holdings to lose value. Annual fees of 0.33% are low for a no-load emerging-markets stock fund. An ETF version of the fund,  Vanguard FTSE Emerging Markets ETF (VWO), is even cheaper, at 0.18%.

 American Funds New World (NEWFX)      
 |  Analyst Rating: Gold  |  Year-to-Date Performance: +1.7%    
Unlike some of its peers, this fund invests a substantial portion of assets (57% as of the end of June) in developed-markets companies, which typically receive at least 20% of revenues from emerging markets, and also holds up to 25% of assets in emerging-markets debt. This ability to diversify results in a relatively conservative portfolio that keeps downside volatility in check is reflected in the fund's low Morningstar Risk rating. The fund lost 14.1% in 2011, a year in which its peers lost 19.9% on average. Three of the fund's seven comanagers have been at the helm since its 1999 inception. The fund may charge a load, but its expense ratio of 1.07% is low for a load fund focused on emerging-markets stocks.

 T. Rowe Price Emerging Markets Stock (PRMSX)         
 |  Analyst Rating: Bronze  |  Year-to-Date Performance: -8.6%       
This fund's deep and experienced management team looks for industry-leading companies with strong growth prospects, favoring large-cap stocks but with an eye on valuations. The fund's country and sector weightings can veer significantly from its peers and relevant indexes, though not to the extent that they have in the past. The fund has performed well in rallies but has produced mixed results in sell-offs. Morningstar fund analyst William Samuel Rocco says the fund is best-suited to investors who plan to hold on for the long term. Its 1.27% expense ratio is below-average for a no-load emerging-markets stock fund.

Performance data as of July 29.