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Step carefully into thriving emerging markets
Emerging-markets funds can be a great diversifier for the long-term investor. If you can accept their risk, ease into the group now and then boost your exposure when emerging markets tumble.
By Timothy Middleton
One thing that characterizes Americans is our boundless optimism. Why else would we invest in emerging markets?
Stocks in developing countries from Russia to Brazil are soaring, in part because American investors are funneling money their way. The average gain this year, as of Sept. 29, has been 5.5% among diversified emerging-markets equity mutual funds. The average small-growth fund, the closest domestic parallel on a risk basis, is down 1.8%.
But these developing countries were growing just as fast in the 1990s. Remember the Asian Tigers? Over the long term, they haven't done squat for investors. The MSCI Emerging Markets Index has fallen an average of 2.2% in each of the last 10 years, as of Sept. 29, despite surging 22.5% in each of the last three.
Investors have short memories. Emerging markets are fabulous, except when theyre melting down, as they did in 1998 and 2000. When theyre hot, the money rolls in. One of the best of these funds, Acadian Emerging Markets (AEMGX), has gotten so overrun, it closed to new investors in August -- a sure sign this is a mania.
Emerging markets are most interesting to speculators, who hope to ride their cycle successfully, and to long-term investors, who enjoy their diversification benefit. Im a mixture of both. I own an emerging-markets fund (Acadian) in my core portfolio, and raise or lower my investment in it opportunistically.
The right portfolio allocation
In coming months, I expect to be lowering my stake. If you dont own emerging markets, and can accept their risk, I recommend dollar-cost averaging into the group over, say, the next four quarters, to establish a core position. Then, wait until the next time they crash to boost that exposure. You can be sure they will.
The diversification benefit of emerging markets is the groups greatest appeal to me. Take a look at this chart.
Last year, both domestic and emerging markets were strongly positive, but in the other nine of the last 10 years they were divergent, and sometimes extremely so. From 1995 through 1998, emerging markets did miserably in comparison with the Standard & Poor's 500 ($INX). But in 1999, and from 2001 to the present, theyve done much better.
This is a vastly greater divergence for U.S. investors than foreign developed markets and, despite the 1999-2000 performance, different also from domestic technology stocks, which are currently in the dumpster.
In my personal core portfolio, emerging markets make up about 25% of my commitment to foreign equity funds, which in turn are 20% of my total equity exposure; thus my core commitment is 5% of total equity assets. I increased that exposure in the flexible portion of my portfolio in 2002, and again early this year, to about 10% of total assets. In coming months, Ill cut that back to 5%.
Low valuations, strong prospects
Im not in any hurry. These bourses are up because these nations are becoming more financially stable, says Brad Durham, managing director for research of EmergingPortfolio.com. As a bonus, valuations are low and growth prospects strong.
Asia is a much lower-risk region than it used to be, and its growing faster than the developed world, says Edmund Harriss, London-based manager of Guinness Atkinson China & Hong Kong Fund (ICHKX). Theyre going to (experience) 6% GDP growth for the next five to 10 years. Developed economies are growing at half that rate.
Latin America has benefited from higher commodity prices (Chile and Venezuela) and market-oriented economic reforms (Brazil). Eastern Europe has benefited from the same factors, commodities in Russia and Poland, and political reforms from the Czech Republic to Turkey.
| Emerging markets performance | | Markets | Year to date, U.S. $ | | MSCI Emerging Markets | 4.3% | | Asia | - 2.4 | | China | - 7.9 | | India | - 7.3 | | Korea | 3.2 | | Eastern Europe | 17.5 | | Russia | 10.2 | | Poland | 18.9 | | Latin America | 12.3 | | Brazil | 7.2 | | Chile | 9.8 | | Venezuela | 41.3 |
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Notes: As of Sept. 29, 2004.
Source: Morgan Stanley Capital International
Clouds rolling in
Even after their big run-up, prices of emerging-markets stocks are seldom more than nine times forward earnings, exactly half the level of U.S. equities. But they trade at a discount for a very good reason -- risk -- and that is rising.
Theres no question the degree of risk over the next year is higher than it was three years ago, when these stocks were dirt cheap, says John Chisholm, chief investment officer of Acadian Asset Management, adviser to the fund I own.
Today they are somewhat cheaper, but not as big a bargain, he says. And there are some storm clouds, which he says include the possibility China will fail to rein in its over-exuberant economy, violence in the Middle East will increase and commodity prices will fall amid a slowing global economy.
Chisholm says hes confident emerging markets will beat the U.S. market over the next five years, and I think thats quite possible. But the ride wont be smooth. The time to buy these markets is when price-to-earnings ratios are closer to six than nine.
That would imply a big correction is due in developing nations, and I wouldn't buy aggressively until it comes. When it does, I wouldn't be surprised to see Acadian Emerging Markets reopen, which would be a strong buy signal.
Other options
In the meantime, investors also can gain exposure to emerging markets through aggressive international funds, such as T. Rowe Price International Discovery (PRIDX). It currently has about 17% of assets in these volatile stocks. Previously closed to new investors, it has reopened.
Outstanding emerging-markets funds that are currently open to investors include Oppenheimer Developing Markets (ODMAX) and Delaware Emerging Markets (DEMAX).
Graph source: Morningstar Inc.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Acadian Emerging Markets, T. Rowe Price International Discovery.
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