How to Participate in the Emerging-Markets Rally

Emerging-markets are on pace for a banner year. Whether further growth expectations are aligned to reality remains an open question.

The MSCI Emerging Market Index is up more than 14% so far this year as of this writing. Why the interest? Poor growth prospects in developed economies have compelled money managers to look elsewhere for better returns. The International Monetary Fund has cut its projections for global growth at 3.1% for this year and 3.4% for 2017--with much of the world's expansion driven by emerging-markets.

In fact, emerging-markets have been on a recovery trajectory since commodity prices plummeted in 2015 as China, the world's largest consumer of commodities, switched its economic growth approach away from a reliance on investment and industry and toward consumption and services. Those emerging economies reliant on commodity exports for their financial stability--including Russia, Brazil and Africa's major economies--suffered the most. More than a year later, investing in these markets seems like an opportunity.

Yet, "the emerging-market rally of 2016 is not really based on fundamentals," says Patricia Oey, a senior fund analyst at Morningstar. "Investors are looking for returns in markets that have underperformed for the past few years."

Given the recent interest in these markets, let's take a look at the risks of investing and share some investment ideas from Morningstar's analysts.

Emerging-Markets Risks Emerging-markets investing is not for the fainthearted. Before investing in this part of the market, it is essential to understand its geopolitical risks.

For example, Turkey is the third largest weight in percentage terms among Europe, Middle East, and Africa in the MSCI Emerging Market Index. The country dragged the index lower late last month after Moody's rating agency downgraded the country's debt to junk status. The downgrade was a result of political deterioration after a faction of Turkey's military tried to overthrow the government in mid-July triggering money withdrawals. This caused Turkish stocks to fall, bond yields to rise, and the lira currency to depreciate.

Another major risk of emerging-markets investing is foreign exchange rate fluctuations. Investing in foreign stocks (and bonds) will likely produce returns in the local currency of the country; but as the local currency's value fluctuates relative to the U.S. dollar, the returns will, too. To wit, if the value of a Brazilian stock increases by 4%, but the real depreciates by 8%, the investor would have realized a net loss in total returns once converted to U.S. dollars.

Economics is another major risk. As some emerging economies depend on commodities for their economic stability, many of those have seen a deceleration of growth or even contraction since commodity prices plummeted last year. In sub-Saharan Africa, for example, the largest economies continue to drag down the region's growth due to lower commodity revenues. Nigeria's economy is forecast to shrink 1.8% in 2016, and South Africa's will barely expand, according to the IMF. China and India however, continue to grow. China is expected to expand 6.6% this year, down from 6.9% last year, while India is projected to grow 7.4% in 2016 and 2017.

But outliers may exist--take Brazil, for example. For the past two years the country has been entangled in a corruption scandal and gone through a crippling recession and a presidential impeachment--all major risks that should've kept investors at bay. And yet, Brazil has seen its stock market and currency soar: The Ibovespa stock market is up 42% so far this year as of this writing and the Brazilian real has appreciated 23% against the U.S. dollar during the same time period.

Morningstar senior fund analyst Gregg Wolper says the rebound in Brazil's market and currency is the main reason the Latin America stock category stands as the top performer of all 15 international equity categories for the year to date as of this writing, with a gain of more than 38%. Brazilian holdings make up more than half of the portfolios of nearly all pan-Latin America funds, says Wolper.

Stock Ideas If the allure of higher growth in emerging-markets is attractive to you despite the risks, there are a handful of stocks in Morningstar's coverage area that are attractive today based on their valuations. All of these stocks are trading in 4- or 5-star range as of this writing, which means they're selling below Morningstar's estimates of their intrinsic worth.

Four-star

Chile's

Fund Picks If you'd rather get emerging-markets exposure via a managed product, look to Morningstar's list of medalists for ideas. Here are a few choices to consider:

iShares Core MSCI Emerging Markets IEMG offers broad exposure to large-, mid-, and small-cap companies across 23 emerging-markets, including Taiwan and South Korea. "Its rock-bottom fee (0.16% expense ratio) and inclusion of small-cap companies set it apart from its peers in the diversified emerging-markets Morningstar Category," says fund analyst Matthew Diamond.

Vanguard FTSE Emerging Markets ETF VWO (0.15% expense ratio) recently transitioned to a new FTSE index that will begin including China A-shares. It is also available in a mutual fund format as the Bronze-rated

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.