Tiptoe into Emerging Markets Stocks

Stocks from developing countries skyrocketed during the recent market rally. The most popular emerging markets stock index stocks more than doubled from its March 3 bear-market low through mid-October. Unfortunately, the index still has to climb another 40% before investors recoup all the losses they suffered in the bear market that began October 9, 2007.

As those numbers illustrate, emerging markets stocks are extremely risky. They produce eye-popping gains during good times and hair-raising losses during bad times. The latest bear-market meltdown—which saw the MSCI Emerging Markets index plunge 65%—was hardly unique. In 1997-98, for instance, emerging markets tumbled 57% largely because of Asian currency collapses.

But patient investors in emerging markets have reaped rich rewards. Over the past ten years, the MSCI index has returned an annualized 9%. That compares to an annualized 2% loss for the Standard & Poor’s 500-stock index.

What’s an investor to do? Are these stocks just to risky to own?

That depends. If you think you would sell during a 50% decline, stay away. But if you understand that bear markets are almost inevitably followed by bull markets, putting 10% or even 15% of your stock money in emerging markets makes good sense.

Stocks have risen in developing countries—countries such as Brazil, China and India—because their economies are growing much more rapidly than the U.S., Japan or the developed countries in Western Europe. They provide cheaper labor than developed countries. And their populations are young, meaning they have enormous numbers of people entering the work force. By contrast, populations of almost all developed countries, including the U.S. are aging. For decades to come, an increasing share of global economic growth is likely to come from emerging markets.

Emerging markets stock prices, moreover, are still reasonable. The price-earnings ratio of the stocks in the MSCI index is about 13 based on earnings over the past 12 months. “Emerging-markets stocks, in general, aren't cheap, but they aren't expensive,” says Chris Laine, one of six managers who steer SSgA Emerging Markets (telephone 800-647-7327, symbol SSEMX).

What to do now? “The easy money has been made,” Laine points out. Emerging markets are no longer screaming bargains. That makes this is an ideal time to begin gradually investing in the sector. Figure out how much of your money you want to devote to emerging markets, then invest one-twelfth of that total every month.

Good emerging markets funds

As in any other sector of the market, it pays to invest in funds that have good long-term records, stable management and low fees. The SSgA fund qualifies on all counts. It’s a “quant” fund—that is, its managers write sophisticated computer programs aimed at identifying attractive stocks. Its returns have matched those of the MSCI index over the past ten years.

If you prefer index funds, Vanguard has your ticket. Vanguard Emerging Markets Stock Index (800-635-1511, VEIEX) charges just 0.32% annually. The exchange-traded version of the fund (known as an ETF) charges even less, just 0.2%, but you have to buy it through a brokerage account.

T. Rowe Price Emerging Markets Stock (800-638-5660, PRMSX) has beaten the MSCI index by an average of one percentage point per year over the past ten years. It may be the best fund for do-it-yourself investors.

The American funds, sold only through advisers, have a fund I like even more. American Funds New World (800-421-0180, NEWFX) is a unique offering. It typically invests two-thirds to three-quarters of its assets directly in emerging markets stocks. The remainder is generally invested in companies in developed markets, including the U.S., that make a large portion of their profits from emerging markets. As emerging markets continue to grow, that’s an increasingly large universe of stocks.

That gives New World two ways to profit from emerging markets. What’s more, this fund is 20% less volatile than the MSCI index. You shouldn’t get quite the breathtaking highs, nor the heartbreaking lows you get in a pure emerging markets fund. But the fund has lagged the index by only one-half of one percentage point over the past ten years. Giving up a smidgen of potential gains in return for lower risk in emerging markets is a trade I’ll make anytime.

October 24, 2009

—Steven T. Goldberg