How Do You Approach Emerging Markets?

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report.

One of the most surprising data points in Morningstar's monthly asset-flows data during the past few years has been investors' appetites for emerging-markets equity funds.

Investors typically send new dollars to categories that have notched strong performance, not the ones that have underperformed. But emerging-markets equity funds have bucked that trend, garnering $43 billion in new flows during the past year even as the category's 4% average annualized return during the past three years lags nearly every other stock-fund category.

To help gauge investor sentiment in anticipation of Morningstar's Emerging-Markets Week, kicking off Monday, Dec. 9, I asked Morningstar.com readers to share their emerging-markets strategies. Do they own dedicated emerging-markets funds, or do they simply own broadly diversified foreign-stock funds that have the latitude to invest in emerging markets?

Responses ran the gamut. Numerous posters said they were taking the surgical approach, buying dedicated emerging-markets funds, region-specific funds, or even individual stocks of companies domiciled in emerging markets. Other posters said they take a more hands-off approach, looking to their foreign-stock funds to supply them with emerging-markets exposure. The majority of respondents said they do both: They look for their diversified-fund managers to supply some emerging-markets exposure, but they also own dedicated emerging-markets holdings.

To read the complete thread or share your own strategy for investing in emerging markets, click here.

'The Day-to-Day Volatility Does Not Seem to Bother Me'
Among those in favor of carving out dedicated emerging-markets exposure was Dziuniek, who's counting on markets to deliver the goods during a long time period. "Due to my long time horizon, I am overweighing emerging markets, mostly using Vanguard FTSE Emerging Markets ETF (VWO). The day-to-day volatility does not seem to bother me too much."

Also employing dedicated emerging-markets exposure is Matthew9, who believes the markets are particularly attractive right now. "I have a mix of emerging-markets funds and ETFs with limited exposure to emerging-markets bonds [and] local government debt," this poster wrote.

Dibbler is taking the active route to investing in the developing markets . "As I believe stock-picking is essential to getting it right, I am prepared to pay slightly higher fees in an actively and well-managed emerging-markets fund with a moderate level of stock turnover to achieve performance. For emerging-markets exposure in my 401(k) I have  Thornburg Developing World (THDIX). The approach the manager takes is to invest in financially sound companies in three broad groups: emerging franchises, consistent earners, and value propositions. U.S. companies that operate in emerging-markets countries account for 11% of the fund. This approach seems to work."

In a similar vein, posters mentioned obtaining diversified emerging-markets exposure via  American Funds New World (NEWFX), which employs an even more diffuse take on emerging markets. Chief K wrote, "I get my emerging-markets exposure through New World Fund, which mixes investments in both emerging markets and in companies located in developed markets that do significant business in emerging markets. I like this approach because I remember reading that the best way to achieve an adequate return on invested capital during a gold rush, is to sell picks and shovels to gold miners."

Not content to invest in a plain-vanilla diversified emerging-markets fund, John883 owns three ETFs in approximately equal weightings:  "About 15% of my portfolio is in emerging markets. Basically equal parts of  Market Vectors Emerging Markets Local Currency Bond (EMLC),  Schwab Emerging Markets Equity ETF (SCHE), and  SPDR S&P Emerging Markets Small Cap (EWX)."

For Racqueteer, Matthews income-oriented Asia funds beckon. (Indeed, the fund family received repeat mentions in the discussion.) This investor owns both  Matthews Asian Growth & Income (MACSX) and  Matthews Asia Dividend (MAPIX) but notes that "my exposure has been greatly reduced during the last few years as a result of both to poor performance in that area generally and outperformance domestically, however. Its time will come again, but not, in my opinion until the global malaise works itself out--and that could take a couple more years."

Lanibay's focus is on developing developing markets. "Emerging markets are so yesterday. I am betting on frontier markets through Wasatch Frontier Emerging Small Countries (WAFMX). The middle class in Nigeria, Vietnam, Pakistan, Kenya, Bangladesh, Morocco, Kuwait, and so on holds the key. I am looking forward to the next 10 years' high volatility but a healthy overall return with low correlation (hopefully) to the developed markets."

Other posters said they also make room for emerging-markets bonds in their portfolios.

Newhandle wrote, "Years ago, perhaps in 2007, in an article on Morningstar.com asking where the Morningstar editors would place their money, one stated that he/she would buy an emerging-markets bond fund. With that, I did, and have always had 5% of my portfolio emerging-markets bonds and have not been disappointed. I don't time my categories, and so I also always have about 10% of stock funds in emerging markets."

But Artsdoc isn't sold on the category's merits. "I stay away from emerging-markets bonds," this veteran poster wrote. "They are expensive to hold and most funds are not hedged. If I'm going to have international-bond exposure, I'll buy high-quality developed-markets bonds which are hedged."

'The Indirect Exposure Suits Me Just Fine'
Other investors said they had eschewed direct emerging-markets exposure in favor of broadly diversified foreign-stock funds.

Favoring the minimalist approach, Tomas47 wrote, "I currently use only  Vanguard Total International Stock Index (VGTSX)."

DBSMichigan, meanwhile, looks to actively managed diversified foreign-stock funds to provide oversight. "Regarding emerging-markets investments, I think it's necessary to invest through a knowledgeable and careful fund manager. I use  Oakmark International (OAKIX), Westcore International Small Cap , Artisan Global Small Cap ,  Oakmark Global Select (OAKWX), and  Wasatch International Growth (WAIGX) rather than emerging-markets specialists so they can rotate in/out as market conditions change."

Macpiano has cut direct emerging-markets exposure. "My strategy is to stay out of [emerging markets]. I sold off all emerging-markets [stocks] and bonds earlier this and will never go back. Too much volatility and too long of a timeline for me. I already have a somewhat volatile international fund, Oakmark International, and it was on a tear last year so I'm cowering in the corner waiting for it to tank. That one I'll take the long time line. It is not an [emerging-markets fund] but sometimes I feel like it acts like one."

Revell10306 has sold off dedicated emerging-markets exposure in the view that positions in  Vanguard International Explorer (VINEX) and Oakmark International supply sufficient inroads into emerging markets. "If the active managers decide to increase their exposure, I'm good with that. I also hold staples, biotechnology, and pharmaceuticals companies which are all targeting the emerging markets, therefore the indirect exposure suits me just fine!"

Other respondents said they employ an even less direct avenue to obtain emerging-markets exposure.

DrBobb was unequivocal. "I do not buy emerging-markets stocks. Instead, I buy multinationals that do business in emerging markets. There is less risk and a pretty good return."

In Rllucky's view, U.S. global giants provide adequate exposure to these growing markets. "I don't feel comfortable in buying funds that are specific to emerging markets. So through my retirement account I invest in the Vanguard S&P 500 index fund, which already has holdings of multinational firms with emerging-markets exposure. And in my personal account I have long term individual holdings of multinationals;  Coca-Cola (KO),  Colgate-Palmolive (CL), and  Diageo (DEO). These provide more than adequate exposure to emerging markets without paying the fees associated with mutual funds."

'I Actually Blend Strategies'
The largest contingent of posters, however, said they do both: They invest in an emerging-markets-specific fund (or funds) but also pick up additional emerging-markets exposure via their diversified foreign-stock funds.

"I actually blend strategies," said Evolence. "One of my core holdings-- Vanguard Total International Stock Market Index (VGTSX)--has cap-weighted, index exposure that includes emerging markets. Outside of that, I seek quality active managers and to exploit value/size factors. Matthews Asia is a very fine fund company, and while some of their funds are not exclusively emerging-markets based, all of the ones I hold have a healthy dose of Asian emerging-markets stocks (for example,  Matthews Pacific Tiger (MAPTX), Matthews Asia Dividend, Matthews Asian Growth & Income). For the value/size effects, I have employed  WisdomTree Emerging Markets Small Cap Dividend (DGS) and  WisdomTree Emerging Markets Equity (DEM)."

Also blending diversified foreign-stock funds with emerging-markets-specific holdings is Sunnywindy. "I have a 30-year-plus time horizon so I'm not worried about the current emerging-markets underperformance. I own Vanguard FTSE Emerging Markets ETF and WisdomTree Emerging Markets Equity (there's almost zero overlap between the two) for direct exposure. I also own  Harbor International (HAINX),  Dodge & Cox International Stock (DODFX), Vanguard FTSE All-World ex-US (VEU), and  Vanguard FTSE All-World ex-US Small Cap (VSS) that all have emerging-markets exposure to various degrees."

Palmreader is a believer in letting diversified-fund managers decide how much to invest in emerging markets but has recently dipped a toe into a dedicated emerging-markets fund. "Historically I've relied on the managers of my international-stock funds to decide whether to invest in emerging markets. Recently, because I like the way the fund's manager communicates with his shareholders (as well as the facts that he seems to make a great deal of sense and has an excellent track record), I've been tiptoeing into a new emerging-markets fund, Seafarer Overseas Growth & Income (SFGIX)."

W004dal is taking the global cap-weighted approach but has added an interesting kicker. "My emerging-markets strategy is very simple: no more than 10% of my overall portfolio is allocated to emerging markets; 90% of my emerging-markets allocation comes from market-cap weighted index of worldwide stocks. And with the remaining 10%, I'm going after the one (financially) overlooked continent for the long haul: Africa (Market Vectors Africa Index (AFK))."

Yogibearbull, for one, finds emerging markets' valuations enticing at current levels and has been adding to his exposures through multiple avenues. "I have been adding to this lagging area directly [emerging-markets stock funds, emerging-markets bond funds] and indirectly [via multisector bond funds, Asian funds, general foreign funds]. The money came from gradually reducing the hot U.S. exposure. Some foreign-stock funds were shifted to the emerging-markets bond funds."

Matthew9 also believes that emerging markets look attractive right now. "For the long-term investor emerging markets look more appealing versus domestic fare," this poster wrote.

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