The 'Chicken' Approach to Emerging Markets Could Be Just the Ticket

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

I often say that if there's a chicken way to do anything in investing, do it. The less you get spooked and jostled around during the investing process, the more likely you are to stick with your plan. That's why I'm a fan of nearly all of the risk-reducing investing ideas in the book: investing in balanced and target-date funds, dollar-cost averaging, and rebalancing. If you cut the volatility risk in your portfolio without greatly diminishing its return potential or paying an arm and a leg (looking at you, alternative funds), I'm all for it. 

In a related vein, that's why I don't typically recommend investments that put too fine a point on a region or market sector. More specialized exposures tend to be more volatile than better-diversified offerings. In addition, they often duplicate what investors have in their portfolios, and they're expensive, to boot. 

Emerging-markets investments are a great case in point. Yes, the return case is there, as my colleague Adam Zoll noted in this overview of emerging markets' risk/reward characteristics. But volatility is also a challenge: The typical emerging-markets fund has a standard deviation that's 5 percentage points higher than that of the average foreign large-blend fund. Investor returns in emerging-markets funds--that is, the returns that investors have actually pocketed when you factor in the timing of their purchases and sales--are notably worse than in diversified foreign-stock funds. 

For that reason, I think most investors' best entry point into emerging markets is via a diversified foreign-stock fund that has the latitude to venture into both developed and developing markets. Russ Kinnel, Morningstar's director of fund research and editor of Morningstar FundInvestor, recently discussed some of his favorite funds of this type, and I decided to use our  Premium Fund Screener to come up with a comprehensive list. 

I screened on broadly diversified foreign-stock funds that have Morningstar Analyst Ratings of Bronze or better, meaning we think they have a good shot at outperforming their peers in the future. To identify funds that have meaningful emerging-markets exposure, I screened for those with 15% or more in emerging markets. I set that hurdle by looking at the amount that broad foreign-stock indexes, such as the MSCI ACWI ex-US Index, stake in those markets. Those hefty emerging-markets allocations will tend to make these funds more volatile than some of their peers, but they could also give the funds an edge if emerging markets do, in fact, emerge from their current torpor.

Eight funds made it through my screen, once I layered on some basic cost and availability criteria--five large caps and three small caps. Here's an overview of some of the funds that fit the bill. To view the screen or make your own tweaks to it,  click here.

 Dodge & Cox International Stock (DODFX)
Category: Foreign Large Blend | Analyst Rating: Gold | % Emerging Markets: 18.55% (as of 9/30/2013)      
No list of foreign-stock funds that have a strong history of navigating emerging markets would be complete without this stalwart. Morningstar senior fund analyst Gregg Wolper notes that there's nothing extraordinary about the managers' value-oriented stock-picking approach on its face, but he says that they execute it with an unusual level of dedication and patience. Although generally bottom-up-focused, one of the managers' overarching beliefs is that faster growth rates in emerging markets merit a consistently high weighting in those markets. Ultralow costs, one of the most seasoned management teams in the business, and exemplary stewardship argue for the fund's continued success. 

 T. Rowe Price International Stock (PRITX)     
Category: Foreign Large Growth | Analyst Rating: Silver | % Emerging Markets: 17.75% (as of 9/30/2013)    
With $13 billion in assets, this Silver-rated offering is far from undiscovered. Yet the fund's asset base is still small enough to enable manager Bob Smith to invest in slightly smaller names than the typical foreign large-growth offering; he also readily considers emerging-markets holdings, as the fund's inclusion here suggests. Morningstar senior fund analyst Bill Rocco is particularly encouraged by the fund's deep team and Smith's record of success at  T. Rowe Price Growth Stock (PRGFX), which he ran for 25 years before taking the reins on the international-stock fund. The portfolio's smaller average market cap and a relatively high emerging-markets stake will tend to produce better-than-average returns in rallies as well as above-average losses during downturns. But its volatility is still lower than that of a dedicated emerging-markets vehicle.

 Thomas White International      
Category: Foreign Large Value | Analyst Rating: Bronze | % Emerging Markets: 15.01% (as of 9/30/2013)    
Thomas White isn't a household name like  T. Rowe Price Group (TROW) or Dodge & Cox, but Morningstar's Rocco thinks this Bronze-rated fund merits the core-holding designation alongside mainstay funds from the big players. The fund lands in Morningstar's foreign large-value category, but its managers employ a relative-value strategy rather than focusing on absolute value. Thus, the portfolio has significant stakes in core/blend and growth stocks as well as value names. Despite its above-average emerging-markets position, the fund's long-term volatility, as measured by standard deviation, has been roughly in line with that of the MSCI EAFE Index, which lacks emerging markets, as well as that of its typical foreign large-value peer.