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3 ways to profit from the overseas boom
Emerging markets have outperformed ours for the past five years, and they're not as volatile as they used to be. These funds should deliver solid, consistent returns.
By Timothy Middleton
You've always needed strong nerves to invest in places like China, India, Brazil and Russia. But, surprisingly, the markets are actually getting tamer.
Emerging-markets mutual funds, though down slightly this year, are outperforming the S&P 500 for the fifth straight year. The MSCI Emerging Markets index finished April down 1.7%, compared with the 4% drop in the domestic benchmark.
But one of the big problems with the emerging markets has been their volatility. In some years, the average fund in the group will rocket 55% higher, as in 2003. In others, the group's returns fall off a cliff, as they did in 2000 with a 30% loss.
"You still have to expect a wild ride in these markets," says Paul Matthews, chairman of Matthews Funds, whose Matthews China Fund (MCHFX) plunged 2.8% in March, trimming its year-to-date gain to 0.3% as of May 11.
But the ride's not as wild as it once was. Risk in developing markets has contracted enormously in the last decade. The average price volatility of the MSCI index has plunged 19.5% in that period, while that of the domestic market has changed little. Third World stocks are about one-third more volatile than domestic shares; 10 years ago they were half-again as risky.
When I wrote about emerging markets last October, I warned that the group, which was surging toward an average gain of 23.8% last year, was vulnerable to a correction. That has begun, and I don't think it's over. But newcomers to these markets should continue to build toward a core holding of 5% to 7.5% of total assets in a diversified emerging-markets equity fund. I recommend getting into the group by dollar-cost averaging -- essentially spreading out your purchases to avoid buying at the top -- over the next year to build the position.
Increasingly in step
The developing world is truly developing, and one consequence is that its bourses are much more in sync with the New York Stock Exchange than they were in the 1980s and 1990s.
As the following chart shows, the MSCI index has gone from wildly divergent from domestic markets to increasingly convergent.
In part, this is because growth in developing markets is slowing but behaving more predictably. Gross domestic product is still surging more than 9% annually in China, but Chinese authorities are aggressively working to slow down that rate. In Indonesia, one of China's principal trading partners, GDP growth is below 7%. In Singapore, it is less than 3%.
Meanwhile, the flow of American capital into these markets has begun to contract after years of explosive growth. Net new flows of money into emerging-markets mutual funds, which peaked at more than $6 billion in mid-March, shriveled to half that level this month, according to EmergingPortfolio.com. In the week ended May 10, there were net outflows.
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In addition to scores of funds that target individual countries or regions, like the Matthews fund, more than 70 diversify broadly, and I think they are the kind that nonexpert investors should choose. Below are three I find particularly interesting.
Crunching numbers and competitors: Quantitative Emerging Markets (QFFOX): As its name suggests, this fund uses computerized screening, in this case to ferret out stocks with below-average prices and above-average earnings prospects. It owns about 70 of them at any given time.
"This is a value and momentum-type strategy," says manager David Nolan, and he admits to a bias toward large-cap value stocks. But, for Nolan, large is a relative term. Companies in emerging countries tend toward the small size; the average market capitalization of companies in Nolan's fund is less than $8 billion. Domestically, that would be considered mid-cap.
The fund shot up 26.8% last year, after an 80.8% surge the year before.
Indexing in an unlikely place: The iShares MSCI Emerging Markets Index (EEM, news, msgs): This is an exchange-traded index fund. The conventional wisdom is that active managers can beat indexing in small, thinly traded markets like those in developing countries, but they haven't lately. Last year, this fund returned 25.5%, more than the average fund in the group.
Part of the fund's outperformance comes from low expenses; just 0.76% per year, compared with 2.02% for the average fund in the group.
I use this fund in my model portfolio of exchange-traded funds.
(Note: Owing to a quirk in our database, this fund is incorrectly labeled iShares MSCI Emerging Markets Income. This is, in fact, an equity fund, and we are working to correct the error.)
Mobius is still the master: Templeton Developing Markets A (TEDMX): Some active managers do earn their keep, and this fund's lead manager, Mark Mobius, pioneered this field and remains its dean. "Mobius and his team practice a patient, low-turnover approach, which plugs nicely into the firm's strong research support -- it has 30 analysts spread over 11 worldwide locations," Morningstar analyst Arijit Dutta wrote in a recent report on the fund.
Mobius's fund is anti-index. It has a 24% weighting in consumer-goods stocks, for example, which is nearly twice the weighting they hold in the MSCI index. It also has only 9% of assets in Latin America, about one-third the index weighting, because it views that region as anti-shareholder.
Out of sight, out of reach
The very best emerging-markets funds, alas, you can't buy. GMO Emerging Markets III (GMOEX) and Acadian Emerging Markets (AEMGX), Nos. 1 and 2, respectively, in the category over the last 10 years, are closed to new investors.
However, if you can gain access to them through a financial adviser or a 401(k) plan, they are superb choices.
As I wrote last October, a real rout in emerging markets would cause me to boost my exposure there very significantly. But if I still hadn't taken the plunge into these volatile marketplaces, I would be building my core position now. Price/earnings ratios in developing markets are still about 18% below those of developed markets, and that will creep toward parity as these markets mature.
And maturing they surely are. "Most emerging-markets debt is now investment grade," says Jeff Lancaster, a principal of Bingham, Osborn & Scarborough, a San Francisco-based investment advisory firm. Mexican and Russian bonds are among those that make up the Lehman Brothers U.S. Aggregate Bond Index. Developing equity markets are following their fixed-income siblings into the First World.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Acadian Emerging Markets.
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