Going global with emerging markets

With their high prospects for growth, some analysts see international stocks leading a global rebound.

By Beth Kowitt, reporter

NEW YORK (Fortune) -- The numbers are in, confirming what many already suspected: Emerging markets are the flavor of the month (or at least the quarter).

EPFR, which tracks global fund flows, reported that during the second quarter, combined emerging market equity funds took in a record $26.5 billion, beating the previous high for a single quarter (the fourth quarter of 2007 with $22.4 billion).

"Emerging market funds have done particularly well in the rebound," says Bill Rocco, senior fund analyst at Morningstar. "There's talk out there that they're going to lead the recovery."

Part of their appeal, says Simon Hallett, chief investment officer of Harding Loevner, is that with developed economies in financial turmoil, emerging markets offer the possibility of faster growth and more financial security thanks to less debt lurking.

"This is a big change," said Hallett in an email. "In the past, they were considered very risky, but it was widely assumed (at least periodically) that investors got paid for taking that risk. Now they appear to have safe-haven status as well as offering the traditional prospect of more growth."

Before stepping into emerging markets, Morningstar's Rocco says most investors should recognize that they likely already have exposure through global equity, natural resources, and core foreign funds. Investors might also be in emerging markets indirectly if they invest in large global companies with operations in the developing world.

While he wouldn't give an exact percentage that investors should allocate to emerging markets, Rocco said it should be "small but significant."

His key piece of advice: Most investors are better off in funds that cover broad geographic ranges instead of specific regions in order to achieve a more balanced portfolio.

"The smaller your geographic region, you're completely vulnerable to a blowup in a given area," he says.

Emerging markets are what Rocco calls "lumpy," meaning they lack sector breadth and are instead concentrated in specific areas such as energy, metals, or banking. So investors may be compounding their risk if they're in a fund that focuses on a particular region on top of lacking sector balance.

If investors do want to concentrate on a particular area, Rocco recommends Asia -- already a huge focus of emerging market funds. He says Asia-centric funds are broader and have more markets and market cap than those that are country or region-specific.

For a regionally diversified fund, Rocco points to T. Rowe Price Emerging Markets Stock (PRMSX), which has a 1.24% expense ratio. It had a rough year (down about 34%), but is up 37% since the start of January, beating out its category's 30% total returns. It also has a solid five-year track record (up 13%). Top holdings include Mexican telecom America Movil (AMX) and Beijing Enterprises Holding, which runs a variety of businesses from beer production to toll roads.

Investors looking for a more conservative emerging market fund might want to consider American Funds New World (NEWFX), says Rocco, which also looks at multinational companies doing business in developing economies.

"It's not going to do as well in an emerging market rally, but it won't fall as far in a sell-off," he says. "It's a conservative way to play the region."

The fund is up about 22% on the year and 11% over five years. Like the rest of its category it took a hit over a one-year period, down about 27%, but its category's almost 31% decline. The fund has a 5.75% sales charge and a 0.95% expense ratio.

American Funds New World holdings include Belgian brewer Anheuser Busch InBev, Russian natural gas producer Gazprom, and Israeli pharmaceutical company Teva (TEVA).

Hallett's Harding Loevner Emerging Markets (HLEMX) also gets a nod from Rocco for what he calls its "good, sensible, high-quality growth strategy." It has a solid long-term track record (up about 13.5% over five years), even though it's down about 30% over a one-year period. It has a 1.61% expense ratio.

Investors should be forewarned that emerging markets have a long history of hot and cold streaks as investors pile in once they start going up and quickly flee when they spot trouble. Their popularity may already be waning. EPFR reported outflows for emerging market equity funds in two of the last three weeks through July 8.

"Aggressive funds in general have this problem, thinking they can time the market," Rocco says. "People focus on what's hot. They want to buy them after they're big." To top of page

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