Why Emerging Markets Belong in Your Portfolio

An S&P strategist calls the asset class a 'must-own' for many investors.

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First things first: emerging markets stock funds are still a volatile asset class. But if you break up the globe into different regions, the countries these funds invest in rank among the most attractive long-term prospects. Why? Because unlike many developed markets in the U.S., U.K., Europe, and Japan, emerging markets have much lower debt burdens and are expected to grow at a much higher rate in the future.

Standard & Poor's estimates that emerging markets account for approximately 80 percent of the world's population and half of global economic output, but only 13 percent of the global stock market capitalization. That's a huge imbalance, and strategists at S&P say the gap will narrow over time.

Alec Young, international equity strategist at S&P, says that for many long-term investors, emerging markets are becoming a "must-own" asset class. "This is something that you want to own over the long run," he says. "It's as important to your portfolio as U.S. stocks, European stocks, treasury bonds, gold, or anything else."

[See U.S. News's list of The 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

In the past, emerging markets were a trendy asset class that would occasionally attract investments. They were also generally the biggest downside losers when global markets fell. Now, emerging markets are posting strong numbers coming out of the downturn, and these funds are beginning to recover their losses at a much more rapid rate compared with some regions of the developed world. "Historically, when markets have hit tough times, emerging markets have fallen more than the U.S., Europe, or Japan, and what we've seen this time around is emerging markets have been pretty resilient," Young says. S&P now recommends that investors put 9 percent of their total equity assets into emerging markets in their growth asset allocation portfolio.

Here's a quick comparison. Since the global stock market officially peaked (before the financial crisis) in October 2007, the MSCI Emerging Markets Index, which is primarily made up of the BRIC countries (Brazil, Russia, India, and China), is now worth about 70 percent of its peak value, according to S&P. That means that if you had a dollar invested in it in October 2007, you would have 70 cents now. Because of a number of factors, including slow growth in Japan and doubts about the strength of the Euro, the MSCI EAFE index, which is mostly made up of international stocks from developed nations like the U.K., Europe, and Japan, hasn't recovered as quickly. It's now worth about 59 percent of its peak value, according to S&P. (U.S. indicies have fared better. The S&P 500 has recouped the most of its losses since the downturn. It's worth about 71 percent of its October 2007 value, according to S&P.)

[See 10 Ways the European Debt Crisis Affects Your Investments.]

Despite improvements in many of these countries, many emerging markets stocks still trade at a discount to other stocks because it can still be difficult to get access to some of the markets and accounting tactics in these countries aren't always as transparent. Young believes that in the future, many of these issues will disappear, which will cause their valuations to rise and be more in line with other investments like U.S. and European stocks. "In 20 or 30 years they won't be emerging markets, they will just be markets, and there will be a new crop of smaller emerging countries," he says. "To the extent you can buy them cheaper today than you buy Western stocks ... you want to take advantage of that because those liquidity and transparency issues will go away over time." That's why, Young says, it's a good time to invest in them.

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S&P has identified two strong-performing emerging markets stock funds that received four out of five stars from S&P's MarketScope Advisor ranking system. S&P's ranking system takes cost, performance, risk, and other metrics into account to come up with a list of highly-rated funds. Schroder Emerging Market Equity (SEMVX) opened in 2006 and has outperformed its peers in each of the past three years, according to S&P. About 75 percent of the fund's total assets are invested in emerging markets countries. More than half of its holdings are in Asia, while almost a quarter are in the Middle East and Africa. Management invests in about 150 total holdings. Some of the largest ones include Samsung (Korea), Petrobras (Brazil), Gazprom (Russia), China Construction Bank, and Teva Pharmaceuticals (Israel). In a recent filing, management says it generally maintains a bias toward mid-cap stocks.