Too Late for Emerging Markets?

By Nancy Zambell, Contributing Editor

Emerging markets, defined by Wikipedia as those countries in transition between developing and developed, have been on a tear for the last few years. The two primary catalysts have been tremendous growth in consumption and rising energy demand. 

Last year, Lipper cited an average return of 32% for emerging market funds, 26% for international funds and 12% for domestic funds. 

However, the summer's credit crunch, due to the United States' subprime nightmare, showed investors that, while emerging markets can bring fabulous returns, they also come with considerable volatility. Investors couldn't get out of the stock markets fast enough in July and August, causing the S&P 500 Index to decline by 9.4%, but hitting the emerging markets much harder, dropping them by an average 14.4%.  

Yet, as fear subsided, the markets rebounded; the Dow hit new highs; and emerging market stocks have surged by 25%, just since Aug. 19. 

And 2007 looks like it will easily surpass last year's gains for emerging markets. So far this year, the MSCI Emerging Market Index is up 41%, and the S&P/Citigroup Latin America Index has risen 51%. In comparison, the S&P 500 is up just about 10%, while Japan is barely breaking even, with a 2% gain. 

Helped by the Federal Reserve's healthy rate cut, which injected liquidity into the markets, cash is once again pouring into emerging market equities. Last week, the Global Emerging Markets (GEM) equity funds saw its largest weekly inflow since January 2006. And more than $5 billion has gone into emerging market stocks since the first week of October. 

The biggest recipients of funds are China, Hong Kong, India, Brazil and Korea. 

Emerging markets have definitely been a boon to many investors' portfolios. But like with all good things, you may be wondering if their time in the limelight is waning. 

I've spoken with many other financial advisors over the past couple of months and have found very diverse opinions as to whether emerging markets are now too pricey for the average investor. I've received equal numbers of views on both sides of the question. 

Certainly, emerging market equities have become much pricier, with price-earnings ratios running about 13.3 times compared to 13.4 for developed countries, according to T. Rowe Price. 

And the summer's financial problems in the U.S. showed us just what ripples in the markets can do to their prices. No doubt, investing in these equities brings considerable volatility to your portfolio. Add in the regulatory issues, political manipulations and high-debt levels in many of these countries, and it's easy to see why investors need to be cautious. 

But there are still many good reasons for looking abroad to supplement your investment portfolio. Emerging market equities: 

• Add diversification to your portfolio.
• Can often substantially boost your returns.
• Benefit from the weak U.S. dollar.

The growing consumption in places like China, India, Brazil and Russia (the BRIC countries) is not abating. Instead—barring any major economic setbacks—those countries are on schedule to see tremendous expansion as they become more capitalistic in nature. Already, they account for one-third of global growth. Additionally, many of their governments have huge cash stockpiles in reserve that are being used to build infrastructure and public works projects. 

That means rising earnings for legions of companies—which in most cases—will lead to rising stock prices. And the investor who exercises caution in his choices should be able to capture some of these gains. 

I believe that the key to investing in emerging markets is caution. Investors must remember that these equities are in countries that have made great strides in opening their borders—and their accounting statements—but still frequently do not adhere to the same kind of accounting standards as U.S. companies, they are substantially affected by prices of commodities and their governments are often shaky. 

Therefore, as I mentioned, investors must practice utmost caution. The number one way to protect yourself against the downside is to limit the portion of your portfolio that is devoted to emerging market equities. I've heard some advisors recommend that investors put up to 65% of their investment funds into China. That's just ridiculous. Five percent to 10% is plenty, for most investors. 

Next, don't chase performance. In the past two years, funds in China have risen by an average of 59%. Therefore, I would recommend that China investments take up a very small portion of your portfolio. Instead, consider some other up-and-coming areas like Latin America, Korea, Malaysia and Singapore. 

Take some of your profits off the table from time to time. That way, you are risking less of your initial capital as you go on. 

Keep your eye on regulatory, economic and political developments in the countries in which you own stocks.  

To spread your risk, invest in exchange-traded funds (ETFs) or mutual funds. You have plenty to choose from. Here are some of the most popular: 

iShares MSCI Emerging Markets Index (EEM) has investments in South Korea (15% of the portfolio), Hong Kong (14.6%), Brazil (12.4%), Taiwan (9.3%) and South Africa (7.7%) among others. Top holdings include Samsung, China Mobile, Kookmin Bank (KB) and Taiwan Semiconductor Manufacturing (TSM).  

Vanguard Emerging Market Stock Index (VEIEX), seeks to track the performance of EEM, and has a very small .42% expense ratio (compared to the 1.83% annual expense ratio of the average emerging market fund). 

Vanguard Emerging Markets Stock ETF (VWO), also seeks to track the performance of EEM, has just a .3% expense ratio.  

T. Rowe Price Emerging Markets Stock fund (PRMSX). The portfolio has a large percentage of its assets in Brazil (12.7%) and South Korea (12.1%), in addition to Latin America, and parts of Europe. Its largest holdings are American Movil, Hon Hai Precision, Bco Itau Holdings and Savings Bank of the Russian Federation. Its expense ratio is higher, coming in at 1.25%. 

Emerging markets are here to stay. There's no reason why you can't continue to participate; just remember to exercise caution, do your homework and monitor your holdings. If you do that, you are likely to spice up your portfolio with many interesting—and profitable—investments.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

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