Morningstar's Favorite Emerging-Markets Funds and ETFs

Note: This article is part of Morningstar's May 2015 International Investing Week special report.

Investors who believe in the merits of rebalancing--scaling back highly appreciated parts of their portfolios and adding to those that haven't done as well--probably have their sights set on bonds right now. After all, fixed-income investments have dramatically underperformed stocks since the current rally began more than six years ago.

But they might also consider giving their emerging-markets stakes a boost at the expense of developed-markets exposure. After all, the MSCI Emerging Markets Index has returned just half of what the MSCI EAFE Index, which focuses on developed-markets stocks, has gained in the past five years. And both foreign developed- and developing-markets equities have badly lagged the U.S. market during that period. On a reversion-to-the-mean basis, emerging-markets equities appear to be due for better performance than developed-markets equities going forward.

Yet, investing in emerging markets requires a few decisions along the way. A crucial one is just how much emerging-markets exposure is enough. Despite all the ink spilled over emerging markets over the past several decades, the market value of all emerging-markets stocks totals still less than 10% of the globe's equity-market capitalization currently. Thus, a crucial first step for any would-be investors in emerging markets is to check their existing exposures: Those with good-quality broad foreign-stock funds, including many index offerings, may have ample emerging-markets exposure already. (Adam Zoll identified some of the top offerings of this ilk in this article.)

Assuming they'd like to add dedicated emerging-markets exposure, investors then need to decide on their delivery system. Will they seek an actively managed fund or an index option?

Based on Morningstar's fund flow data, investors appear to be casting their lots with index products: Not only are some of the best active funds closed to new investors, such as Silver-rated

But senior analyst Patricia Oey says that investors should be sure to understand what they're getting into before buying an emerging-markets index fund. In particular, she notes that market-cap-weighted emerging-markets index funds tilt heavily toward China right now. The MSCI Emerging Markets Index, for example, stakes a fourth of its assets in China currently, and Oey notes that weight will grow if and when MSCI adds onshore Chinese stocks (A shares) to the index. FTSE is also planning to add onshore Chinese stocks to its emerging-markets index. (Of course, Chinese stocks could fall between now and then, so the addition of A shares might not be as significant as it would seem to be today.) Such a large emphasis on a single country--albeit one with the second-largest economy in the world--carries risks, which arguably are especially acute today. As Morningstar markets editor Jeremy Glaser discusses in this video, Chinese stocks are currently among the most overvalued in Morningstar's coverage universe.

Here's an overview of some of Morningstar's favorite traditional mutual fund and index fund/exchange-traded fund picks that land in the diversified emerging-markets category and are accepting new investor dollars. Premium Members can click

to view a screen for all of the diversified emerging-markets medalist funds that are currently open to new investors; note that this screen does not encompass exchange-traded funds, but I've named some of Morningstar's favorite ETFs in the index-fund section below.

Diversified Emerging-Markets Funds: Active

American Funds New World, the sole Gold-rated actively managed diversified emerging-markets fund, employs an approach that is quite different from most of its peers. While most rival funds focus on stocks of companies domiciled in emerging markets, this fund takes a more diffuse approach, investing in developed-markets companies that derive at least 20% of their revenues from emerging markets, as well as emerging-markets bonds. That diversified approach has helped limit losses during down markets, contributing to a fine long-term risk/reward profile, though it has lagged when emerging markets have surged. Note that investors may need to pay a sales charge to gain entry to the fund.

Although it invests much more heavily in companies domiciled in emerging markets than does American Funds New World, senior analyst Bill Rocco notes that this fund has also historically held up well on the downside, while lagging a bit in go-go rallies for emerging markets. While maintaining a growth focus, management also keeps its eyes on quality, seeking companies with clean balance sheets and sustainable competitive advantages, among other attributes. Rocco also notes that the fund's China stake, while it has grown in the past year, is still lighter than that of its typical peer and substantially smaller than that of the MSCI Emerging Markets Index.

Diversified Emerging Markets Funds: Index

The sole medalist offering among traditional index funds, this fund carries a rating of Bronze in large part because of the lasting benefits conferred by its ultralow costs. The Admiral and ETF share classes of this fund are even cheaper--at 0.15% currently. But it currently has roughly a fourth of its assets in Chinese equities, and that stake would grow even larger if FTSE, which oversees the index that it tracks, adds onshore Chinese equities (A shares) to the benchmark. (As noted above, however, there's the possibility that the Chinese market could fall between now and then.) Note that that caution also applies to other capitalization-weighted emerging-markets index funds, including the popular

Like other low-volatility index products, this emerging-markets index fund is set up to exploit "the low-volatility anomaly"--research demonstrating that the subset of low-volatility stocks will tend to outperform portfolios with higher price fluctuations over the long term. While this fund has only been around since late 2011, the benchmark it tracks has soundly beaten the market-cap-weighted MSCI Emerging Markets Index during the past 10- and 15-year periods, with less volatility to boot. However, Oey cautions investors not to equate a low-volatility strategy with low risk; the fund invests in emerging markets, after all, and its exposure to the soaring Chinese market is every bit as high as the cap-weighted indexes.