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New Approach Puts Investments 101 to the Test

RUSS WILES, <i> a financial writer for the Arizona Republic, specializes in mutual funds. </i>

The new Vanguard Emerging Markets Portfolio, an index fund targeting developing nations, might just be the year’s biggest investment oxymoron.

There’s nothing wrong with mutual funds that invest in the stock markets of developing countries--places like Mexico, Indonesia and Turkey.

Nor is there anything unusual about index funds per se, which seek to replicate, rather than beat, the performance of a broad market barometer.

But mixing an index approach with an emerging-markets format, as the Vanguard fund will do when it starts investing Wednesday, is a contradiction. It’s the type of combination that, if successful, could stand a lot of what we learned in Investments 101 on its head.

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Here’s why:

With an indexing approach, investors are trying to match the market’s results, not outperform it. They do this by holding the same stocks (or at least a representative sample) as can be found in a broad market average or index.

The strategy is assumed to work best using indexes, such as the Standard & Poor’s 500, that are filled with big, established companies. These stocks are said to be “efficiently” priced, in the sense that they’re widely followed by professional analysts, who will quickly bid up or down prices to reflect any corporate news or developments.

These factors make it hard to earn extraordinary profits on efficient stocks or groups of stocks--the main rationale for indexing.

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Yet emerging stock markets are by their very nature inefficient. They constitute small, obscure investment arenas that aren’t carefully picked over by professionals. By implication, good fund managers doing hands-on research should be able to uncover exceptional bargains.

“Emerging markets offer a tremendous opportunity to add value,” says Mark Geist, president and chief operating officer of the Montgomery Funds in San Francisco.

“It’s generally recognized that the emerging markets are the most inefficient markets in the world,” he says.

Geist, whose firm unveiled one of the first emerging-markets funds in March, 1992, says he agrees with the indexing idea in general.

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“But indexing an inefficient market doesn’t make sense,” he says.

That sentiment seems to be shared by others.

“We’re struggling with that same question,” says Tom Connelly of Keats, Connelly & Associates, a Phoenix financial planning firm. Although a big fan of indexing and Vanguard in general, Connelly says he has doubts about the concept when applied to emerging stock markets.

Yet Vanguard, a Valley Forge, Pa., company that ranks as the nation’s second-largest fund group, has an ace up its sleeve: lower expenses.

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Simply put, it costs more to buy and sell stocks in inefficient markets. In part, this reflects the generally poor liquidity of inefficient markets--the presence of fewer buyers and sellers means higher transaction costs generally. In addition, investors in some countries must grapple with various taxes on trading and other costly restrictions.

Brokerage commissions and exchange fees for institutional investors run 8 to 35 times higher in Indonesia than in the United States, Vanguard says.

Because index funds aren’t actively traded, they don’t engage in nearly as much buying and selling as other funds. This allows them to shave their transaction charges and operating expenses.

Vanguard estimates that shareholders will pay about 0.6% a year in operating costs on its Emerging Markets Portfolio--equivalent to a charge of $60 on a $10,000 investment. That compares with expenses of about 2%, or $200 for each $10,000 investment, for existing emerging-markets funds.

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And these numbers don’t even consider the impact of brokerage charges and other transaction costs, which aren’t included in a mutual fund’s “expense ratio” but do exert an impact on performance.

The Vanguard fund intends to hold a representative sample of about 300 stocks in 12 unequally weighted markets--Malaysia, Hong Kong, Thailand, Indonesia, Singapore and the Philippines in Asia; Mexico, Argentina and Brazil in Latin America, and Turkey, Greece and Portugal in Europe.

These countries are included in the Morgan Stanley Capital International Select Emerging Markets Free Index, the mouthful of an index that the Vanguard fund hopes to parallel.

These nations include some of the most mature markets in the emerging sphere, such as those in Mexico, Singapore and Hong Kong. The latter two, especially Hong Kong, are often classified as established markets.

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“I’m not thrilled about putting Hong Kong and Singapore in an emerging-markets fund,” says Connelly.

The mix also ignores some of the least researched and nascent markets, where some of the best opportunities may lie. These could include places such as Sri Lanka, Eastern Europe and the Middle East, says Geist.

Speaking of transaction costs, it’s worth noting that the Vanguard Emerging Markets Portfolio comes with more charges than the typical low-cost Vanguard fund.

It will impose a 2% fee to purchase shares, and a 1% fee to sell. These charges aren’t “loads” in the true sense, as the money is retained by the fund rather than paid to the management company or a brokerage, but they are charges nevertheless. These fees aim to keep the fund’s own costs down by discouraging investors from trading frequently.

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The fund will also levy a $10 account-maintenance fee for all shareholders.

Vanguard already operates two other international index funds, but it hasn’t exactly set the world on fire with them.

The company’s European index fund, which invests in large, established Western European companies, has earned an “average” rating for risk-adjusted performance from Morningstar Inc. of Chicago. But Vanguard’s Pacific index fund, which mostly holds large Japanese stocks, is graded “lowest.”

By contrast, Vanguard’s two actively managed foreign funds, the International Growth and Trustees’ Equity International portfolios, have “average” ratings from Morningstar.

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The New England Funds of Boston, formerly known as the TNE group, will offer a unique path to stock market diversification starting in June, when its New England Star Advisers Fund debuts.

The company is touting this as the first open-end portfolio run by managers at four separate fund companies. The lineup consists of Edward Keely of the Founders Growth Fund, Warren Lammert of Janus Mercury, Barbara Friedman and Jeffrey Petherick of Loomis Sayles Small Cap; and William Berger and Rod Linafelter of Berger 100.

Each of the four teams will receive an initial allocation of 25% of fund assets, and new cash coming into the fund will be apportioned equally.

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Star Advisers ((800) 343-7104; $2,500 minimum) expects to start selling shares around June 20, with prospectuses available in early May.

It carries a maximum sales charge of 5.75%--an interesting wrinkle considering that investors can purchase Founders Growth, Janus Mercury, Loomis Sayles Small Cap and Berger 100 without paying a load.

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The Sierra Trust Funds group of Los Angeles has become one of the latest families to waive annual fees on individual retirement accounts.

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The firm’s “Free IRA for Life” program eliminates a $15 annual fee and $5-per-fund purchase charge on newly opened IRAs. Sierra Trust also will waive its front-end sales charges for people who transfer their IRAs from another load group’s stock or bond funds.

Sierra Trust ((800) 222-5852) has 15 funds with assets of about $3 billion. They can be purchased at Great Western Bank branches and selected brokerages and financial planning firms.


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