FUND WATCH


What's Going on With Emerging Markets?

Emerging markets have great promise, but they're also notoriously volatile. Here's how to invest prudently.



Emerging markets are seemingly in freefall and are dragging down the funds that invest in them. So far in May, diversified developing-market stock funds have plunged 11% on average. Is this just a normal dip for a historically volatile investment category? Or is it a sign that the party is over? Is it time to sell, or should you hang on?

If you arrived early enough, the festivities in emerging markets have been nothing short of spectacular. By the end of April, the average emerging-markets fund had gained an astonishing 198% over the previous three years. Those gains had pulled up the ten-year average return for the category to 9% annualized.

But don't let the ten-year number fool you. Before the start of 2003, emerging markets gave investors far more grief than gains. The story always sounded good. Investing in emerging markets -- places such as Brazil, China, India, Poland and Russia -- was a sure thing because of rapid growth spurred by globalization and the presence in many developing nations of youthful and energetic work forces and plenty of raw materials. But it never worked out.

Worse, emerging markets were a tease. They would deliver great returns in some years, only to plummet by the time most investors took notice. In 1993, for instance, emerging-markets stock funds soared 78%, on average. Over the next five years, the typical fund lost money in all but one year. Then the pattern would repeat. In 1999, the funds rose 70%, only to fall the next three years.

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The problems were manifold. Many companies in developing nations seemed to be run for the benefit of their managers, not their shareholders. Corruption was rampant. It was impossible to find accurate information about many companies. Infrastructure -- basic things like reliable roads and electrical power -- were often lacking. In 1997-98, the "Asian contagion" currency crises swept through emerging markets, triggering huge currency devaluations and economic decline.

But things really do look different this time -- at least to some degree. The emerging markets, almost without exception, are running trade surpluses rather than deficits. That strengthens their currencies. Some companies and governments have learned hard lessons. No, investing in emerging markets isn't like investing in an SP 500 index fund. But it's safer than it used to be.

No one knows what will happen in the short term. Concerns about rising interest rates and what that portends for economic growth in developed nations, particularly the U.S., have spooked investors in emerging markets because those nations are so dependent on exports. But price-earnings ratios are reasonable. Emerging-market stocks trade, on average, at 12 times estimated 2006 profits, according to IBES Consensus Estimates. At the same time, earnings are expected to grow in the mid teens.

Given the potential in emerging markets, it makes sense for investors to put 5% or even 10% of their stock money into emerging markets. Before you buy an emerging markets fund, though, examine the holdings of any broad-based foreign stock funds you own -- diversified funds may have significant stakes in emerging markets.

Among emerging-markets funds, a few stand out. Two of the best are T. Rowe Price Emerging Markets (symbol PRMSX) and SSGA Emerging Markets (SSEMX). Their fees are relatively low, and each fund has beaten the MSCI Emerging Markets index by a little more than five percentage points per year, on average, over the past ten years. If you prefer an indexed approach, consider Vanguard Emerging Market Stock Index (VEIEX) or its exchange-traded-fund sibling, Vanguard Emerging Markets Stock Index Vipers (VWO). Whatever fund you choose, buy in slowly, a little bit every month. Dollar-cost averaging is particularly appropriate for funds as volatile as these are.

--Steven Goldberg




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