Are Emerging Markets a Buy?

Emerging markets look cheap. Or is Europe the true pocket of opportunity? Or perhaps Japan's current rally has staying power?

Investors may have recently heard various market experts suggesting that foreign stocks have better upside potential than U.S. names. The most straightforward way to profit (potentially) from such an idea is to simply boost a portfolio's exposure to a broadly diversified foreign-stock fund--whether an actively managed offering or index fund--and call it a day.

But how about for investors who would like to be more opportunistic, perhaps giving a slight tilt to truly undervalued foreign-domiciled names while de-emphasizing the parts of foreign markets that appear to have less upside potential? Which portfolio additions will give them the biggest bang for their rebalancing buck?

In that case, there appears to be some smart money converging around emerging-markets stocks. But enthusiasm for emerging markets isn't universal, based on a survey of the weightings of Morningstar's top-rated actively managed foreign-stock funds. While some of Morningstar's Gold-rated offerings currently have heavy weightings in emerging markets--including more exotic markets like Africa and the Middle East--other well-regarded funds are sticking with developed markets, primarily in the U.K. and Europe. (Interestingly, nearly all of the Gold-rated active funds are currently downplaying Japanese equities--a rare point of consensus among all of these top-rated offerings.)

The Case for Developing True believers in reversion to the mean would probably tend to favor emerging markets--or at least a broadly diversified foreign-stock fund that includes ample exposure to them. After all, the MSCI Emerging Markets Index has gained just a bit more than 1% on an annualized basis during the past five years. Meanwhile, the MSCI EAFE Index--which excludes emerging-markets stocks--has gained about 6% annualized during the past five years.

Asset-allocation guru Bill Bernstein asserted in a video last fall that emerging-markets stocks look relatively undervalued. GMO's co-head of asset allocation, Ben Inker, recently stated that emerging markets--and particularly the value stocks within emerging markets--look inexpensive relative to developed-markets names. On the flip side, developed-markets foreign stocks--even those of European firms--have actually performed pretty well over the past several years. As senior analyst Kevin McDevitt pointed out in this article, U.S. investors just haven't benefited from their gains because the dollar has appreciated versus major foreign currencies.

What the Funds Say Meanwhile, the emerging-markets weightings in Morningstar's Gold-rated foreign-stock funds tell a more nuanced tale. The most recently available portfolios of the eight actively managed offerings that currently earn Gold ratings and reside in Morningstar's foreign large-cap or small-/mid-cap categories reveal that these funds were generally more sanguine on emerging markets than their category peers. But their opinions on the attractiveness of emerging markets were--pardon the pun--all over the map.

• Median Emerging-Markets Weighting for Gold-Rated Foreign-Stock Funds: 8.5%
• Median Emerging-Markets Weighting for All Foreign-Stock Funds: 5%

These data carry a few important caveats. First, definitions of emerging markets can vary, and the one used by Morningstar may not line up with what's on fund-company websites. I used Morningstar's data to facilitate apples-to-apples comparisons, even though a more current depiction of emerging-markets exposure may be available on fund-company websites.

Second, it's worth noting that portfolios can gain exposure to emerging markets in a variety of ways. Funds can buy shares of emerging-markets-domiciled firms directly, which will show up in their weightings. Alternatively, they can obtain such exposure indirectly, buying developed-markets names that stand to benefit from developments in emerging markets. The fact that a given fund is light on direct emerging-markets exposure shouldn't necessarily be construed as bearishness.

Emerging-Markets Bulls Artisan International Small Cap--the sole small-/mid-cap foreign-stock offering to earn a Gold medal--had the highest emerging-markets weighting of the Gold-rated foreign-stock funds, at 31% as of the end of December 2014. A sizable stake in China--26% of equity assets as of the end of March 2015, according to data on Artisan's site--represents most of that position. Although slowing growth in the region has weighed on corporate profitability, senior fund analyst Greg Carlson noted that managers Mark Yockey and Charles-Henri Hamker expect significant improvement from their holdings there. (The fund is closed to new investors.)

Dodge was emphasizing a broad swath of emerging-markets-domiciled firms as of its most recently available portfolio: Its managers had a slight overweighting in stocks in Asia's emerging markets, per Morningstar's data, as well as in Latin America, Africa, and the Middle East.

Meanwhile, the two American funds had a significant emphasis on emerging-markets names in Asia as of their most recently available portfolios. That positioning was particularly pronounced for EuroPacific Growth, which had 16% of equity assets in such names versus just 7% for the foreign large-growth category.

Emerging Markets? Not So Much But before investors get carried away with the notion that emerging markets are the place to be, let's look at some countervailing evidence. Even as four of the Gold-rated foreign-stock funds were emphasizing emerging-markets names as of their most recently available portfolios, the other four Gold-rated offerings had emerging-markets weightings that were in line with, or lower than, their category peers. And all four of those offerings operate with value biases. So, even though emerging markets may be cheaper than they have been in the past, these managers don't consider them especially attractive on a bottom-up basis right now.

The light emerging-markets stakes in the other two funds are more telling, however, because their managers have, at times, invested in those markets. Oakmark International had less than 2% in stocks domiciled in emerging markets as of its most recently available portfolio, whereas

, Oakmark International's lead manager, David Herro, sounded a sanguine note about the implications of reform for the Chinese economy and noted that the portfolio has significant exposure to the Chinese consumer. However, the portfolio's light stake in emerging-markets stocks indicates that Herro and comanager Rob Taylor are obtaining that exposure indirectly versus buying Chinese stocks straight up.

Harbor International also had a low emerging-markets weighting as of its most recently available portfolio--just 3% of equity assets--even though it has not historically shied away from such markets. Instead, the fund had the most robust weighting in Europe of any of the Gold-rated funds discussed here--68% of equity assets versus just 40% for its typical foreign large-blend category peer.

What to Do

Investors can approach these data in a variety of ways. They can simply buy--or stick with--a broadly diversified, actively managed foreign-stock fund and entrust that manager with the decision about how much emerging-markets exposure to hold at any given point in time. Alternatively, they can look a foreign-stock index fund--either a traditional index fund or ETF--that includes exposure to emerging markets. Morningstar's two Gold-rated picks in this vein are