Emerging market funds take a back seat

For most of the last two years, emerging market stock funds were money-making machines.

Economic growth in countries such as China and India was far outpacing that of the U.S. and Europe. And governments in countries with developing economies weren't burdened with the huge government debt afflicting the U.S. and other fully industrialized nations.

But investors got a surprise in the first quarter as emerging market funds as a group eked out a meager gain of less than 1%, compared with average total returns of 6% for U.S. stock funds and 5.3% for European funds, according to fund tracker Lipper Inc.

The underperformance stemmed partly from renewed hope for growth in developed countries, rather than big problems in the emerging world. Still, the lackluster performance seemed to back the increasingly widespread notion that the biggest gains in emerging markets already have been made.

Although economic growth in those markets is likely to remain strong for years, it's expected to slow a bit in some major countries such as China, Brazil and Mexico.

In addition, emerging economies are grappling with the possibility of rising inflation. And although valuations of emerging-market stocks and funds aren't overpriced, they're not bargains either.

"We can have a very good year, but the easy money is gone," said Tom Roseen, senior analyst at mutual fund tracker Lipper. "Now we're getting back to reality. I expect we'll have high-single-digit returns, and we should be very happy with that."

Since plummeting 56% in 2008 during the global financial crisis, emerging market funds have erased most of that decline after soaring 78% in 2009 and jumping 20% last year.

Despite the first-quarter slowdown, managers of the funds remain upbeat.

"There is a tremendous amount of opportunity in all of these markets," said Patricia Ribeiro, lead manager of the American Century Emerging Markets fund.

A key issue is inflation, many experts said.

To tamp down rising consumer prices, several countries have been raising interest rates, risking a slowdown in economic growth. China last week boosted rates for the fourth time since October, in part to cool its scorching housing market.

Inflation is particularly worrisome in emerging countries, where rising food and energy prices weigh heavily on the underclass, said Simona Mocuta, economist at IHS Global.

"Right now I don't think most emerging markets are into that red-hot danger category, but clearly they are moving in that direction," Mocuta said.

Still, rising inflation would mean different things to different countries. Oil exporters such as Russia could fare much better than India, a heavy oil importer.

Bulls said that even reduced growth rates will be enough to power the markets higher.

"We're confident that emerging markets are going to continue to be the dominant driver of global economic growth," said Alec Young, international equity strategist at Standard & Poor's Corp. "And that's going to happen regardless of whether China grows 10% or 8% or whether Brazil grows 7% or 5%."

Still, fund investors must be careful about overpaying after the sector's blazing rally since its October 2008 low.

Fund managers said they're still finding good stocks to buy, but acknowledged that valuations are getting high in some areas.

Laura Geritz, co-manager of the Wasatch Emerging Markets Small Cap fund, has lightened her holdings in China as prices have risen.

Emerging market stocks are trading near their long-term averages, according to FactSet Research Systems. Based on 12-month projected profits, the price/earnings ratio of the MSCI emerging market index is 11.3, compared to a five-year average of 11.9 and a 10-year average of 11.

By some measures, individual investors are light on emerging market stocks.

Developing countries comprise 28% of global gross domestic product, according to Vanguard. But because some countries restrict access to their markets, the stocks in emerging markets make up only 14% of the MSCI All Country Investable Market Index, a broad measure of global stock market capitalization. China, for example, bars outside investors from key economic industries such as energy and basic materials.

Still, even after heavy inflows into funds in recent years, U.S. investors have only about 6% of their assets in emerging market funds.

Vanguard recommends that investors earmark 20% to 40% of their equity portfolio to foreign stocks. Of that, the fund giant suggests devoting to emerging markets one-fourth of that foreign allocation, or 5% to 10% of an overall equity portfolio.

Chris Philips, senior analyst in Vanguard's investment strategy group, said boosting an emerging market allocation can be a wise move — as long as it's done to increase diversification and overall international exposure. Given that the developing world's strong projected growth rates already are reflected in their stock prices, investors shouldn't be jumping in expecting huge gains, he said.

"It's encouraging to see assets and cash flows going where they are," Philips said. "But our concern is: Are [investors] going for the right reasons? Are they going for diversification or are they going because they've seen emerging outperform other markets?"

Above all, experts said, don't panic when bad times come.

Investors "get way too emotional about the swings" in developing markets, S&P's Young said. "The reality is if you don't have the stomach to ride out the volatility you won't be around long enough to capture the long-term promise."


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