11 Ways to Play Emerging Markets

"The best thing about investing in emerging markets is that they periodically get good and cheap." 

The inimitable Bill Bernstein made that comment at one of the Bogleheads conferences several years ago, going on to say that the best time to buy into emerging markets is when they're on sale. 

His point was corroborated by a Vanguard study demonstrating that market valuations, not GDP growth, are the best predictor of emerging markets' subsequent performance. 

But a look at the most recent dollar-weighted returns, or "investor returns," for emerging-markets funds shows that many investors haven't timed their purchases well at all. Whereas the typical diversified emerging-markets fund has gained an annualized 11.3% over the past decade through July 31, 2014, the typical investor in such a fund pocketed an 8.4% gain. The shortfall owes to timing errors--the fact that investor dollars often pile into an asset class when euphoria is running high (and valuations are high to match) and run out after the markets have dropped and valuations are relatively better. In short, many investors do just the opposite of what Bernstein would advise. 

Morningstar's quantitative equity ratings suggest that investors who want to buck the bad-timing trend--and find value in a market that looks fairly valued overall--should consider emerging markets today. In a recent video, Morningstar analyst Tim Strauts noted that emerging-markets equities, especially those of companies domiciled in Brazil, Russia, and China, appear relatively attractive on a bottom-up basis currently. (India, the "I" in BRIC, is a notable exception and is significantly overvalued at current levels, based on the quantitative price/fair value ratios, Strauts noted.) Those relatively attractive valuations stand in contrast to developed-markets valuations, with companies based in the U.S. and in most of developed Europe currently trading above their quantitatively derived fair values. 

Of course, you may well have ample emerging-markets exposure in your portfolio already.  Morningstar's X-Ray Overview page gives you a breakdown of your portfolio by major geographic region. If X-Ray shows that your portfolio's combined exposure to Latin America, emerging Asia and Europe, and Africa and the Middle East totals more than 10%, you're already tilting more heavily toward emerging markets than is the case for broad, cap-weighted world-stock indexes. 

But if you're underweight in emerging markets or are comfortable making an outsized bet there, there are a couple of ways to play it. You could obtain exposure directly, by purchasing shares of individual companies based in emerging markets or by buying an emerging-markets-focused mutual fund or ETF. You could buy a fund focused on a specific region, such as emerging Asia. Alternatively, you could add to a diversified foreign-stock fund that has broad latitude to invest heavily in emerging markets. 

Here's a survey of some of Morningstar's best ideas to accompany each of those strategies. 

The Stock-Picker:  Telefonica Brasil (VIV),  Vale SA (VALE)
Morningstar's quantitative equity ratings indicate that stocks in Russia, Brazil, and China look undervalued right now. (Note that these ratings are different from the Morningstar Analyst Ratings, as discussed here.) While no Chinese or Russian stocks currently receive star ratings of 4 or higher and moat ratings of narrow or better from our equity analysts, a handful of Brazilian companies do. They include Brazilian phone giant Telefonica Brasil, which Morningstar analyst Imari Love describes as "an attractive defensive bet on an emerging market," citing its solid dividend and balance sheet. Brazil's Vale SA, the world's largest iron-ore mining firm, also has a 4-star rating currently, as well as a narrow moat. While moats are difficult to come by in the mining sector, analyst Dan Rohr believes that Vale's low-cost production affords it a lasting advantage. 

The Indexer:  Vanguard FTSE Emerging Markets ETF (VWO) or  Vanguard Emerging Markets Stock Index (VEMAX),  Schwab Emerging Markets Equity ETF (SCHE),  iShares Core MSCI Emerging Markets Index (IEMG) 
There has been an explosion of index funds and exchange-traded funds dedicated to specific slices of the emerging markets, including vehicles that focus on low-volatility and small-cap stocks, as well as specific sectors. But for investors who are attracted to index products because of their low costs, market-cap-weighted funds and ETFs will tend to be the most cost-effective way to gain access to these markets. Morningstar's analysts like Vanguard Emerging Markets, both the ETF version and the traditional index mutual fund, as well as Schwab's ultra-cheap Emerging Markets Equity ETF. Morningstar analyst Patricia Oey also recommends iShares Core MSCI Emerging Markets Index. While it has a slightly higher price tag than Vanguard or Schwab's emerging-markets index products, it includes a dash of emerging-markets small caps. 

The Fund-Picker:  American Funds New World (NEWFX),  T. Rowe Price Emerging Markets Stock (PRMSX)
The returns of index products dedicated to emerging markets have been competitive (or better, depending on the time period) with those run by active managers. But beaten-up markets don't always spell buying opportunities, so some investors like the idea of an active emerging-markets manager steering the ship. Morningstar's top-rated actively managed pick in the diversified emerging-markets category is American Funds New World, in part because it has been much less volatile (and therefore easier to own) than other emerging-markets funds. But prospective investors should be mindful of the fact that its emerging-markets stock exposure recently stood at less than 30% of assets. (The fund also buys developed-markets equities from companies that do a big share of their business in emerging markets, as well as emerging-markets bonds.) As such, it's arguably not the best way to play potential undervaluation in emerging-markets equities.

Among Morningstar's Medalist funds, the Bronze-rated T. Rowe Price Emerging Markets Stock is one of the best actively managed options for no-load retail investors. Its manager, Gonzalo Pangaro, has worked on the fund for more than a decade, and he's backed by a deep team of analysts and portfolio managers who work on T. Rowe's lineup of emerging markets region-specific funds. 

The Regional Specialist:  Matthews China (MCHFX)
Among mutual funds that focus on a specific region, the suite of offerings managed by Matthews, an Asia specialist, are the cream of the crop. The firm is so dominant, in fact, that it manages six of the nine Medalist funds in Asia-focused categories. For investors aiming to play potential undervaluation in Chinese stocks, the Silver-rated Matthews China stands out as a solid choice. Returns have been underwhelming relative to other China-focused vehicles over the past few years, but senior analyst Bill Rocco notes that its experienced management team uses the same stock-picking strategy that Matthews has employed with great success on its other charges. 

The Diversifier:  Dodge & Cox International Stock (DODFX),  Manning & Napier World Opportunities  
For those who would like to be hands-off on the emerging-markets question--giving their managers the latitude to emphasize or downplay emerging markets as they see fit--Morningstar analysts have a few favorites that fit the bill. Among these, the Gold-rated Dodge & Cox International is easy to recommend. Its emerging-markets weighting currently totals nearly 20%, as the fund's management team dove into emerging markets in 2013 even as many of their peers were retreating. 

Manning & Napier World Opportunities is another Gold-rated option with a good deal of flexibility to under- or overemphasize certain markets as its managers see fit. The fund currently has a sizable overweighting in Latin America, especially Brazil.

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