Emerging Markets: Proceed With Caution

Emerging markets might still be hot, but there’s plenty to think about before diving in.

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Recent news of rising inflation in emerging markets has many investors feeling nervous. Several countries, including China, Indonesia and India, have already begun tightening monetary policy and hiking interest rates to rein in rapid price increases, actions designed to slow down their superheated economies.

The combination of slower growth and rising prices will produce a much less certain environment for investors, many of whom reaped the benefits of a decade of stellar economic growth from the group. But even though inflationary pressures are likely to dampen economic growth a bit, experts still expect emerging economies to continue growing at a faster pace than developed nations. According to the International Monetary Fund, advanced economies are projected to expand by about 2.5 percent in 2011, while emerging markets are expected to grow by 6.5 percent (a modest decline from the 7 percent growth the group posted in 2010).

Furthermore, experts say countries such as India and China are well equipped to deal with the ripple effects of meteoric economic growth. "The Chinese and the Indian governments have in the past been able to manage their inflation," says Rob Lutts, president and chief investment officer of Salem, Mass.-based financial services firm Cabot Money Management. "They're going to do the same thing here. It's likely an opportunity rather than a time to exit and stand clear."

[See Forget the BRICs: How to Invest in Emerging Markets.]

But where there's opportunity, there's also plenty of risk and reason to be wary. "I would, in general, recommend a very cautious approach to emerging markets right now," says Morningstar analyst Kevin McDevitt. "Given how strong they've been over the last decade and given the amount of money we've seen flowing into these categories, our concern is that investors might be getting in at unattractive prices." U.S. News talked to the experts to find out which strategies work best in the current market climate.

Go broad-based. Although they experience periodic spells of volatility, emerging markets as a group have sustained relatively high levels of economic growth over the past decade. That, coupled with several years of lackluster performance from developed economies such as the United States and Europe, has caused many investors to flock to emerging markets, driving up valuations. For that reason, McDevitt stresses that investors shouldn't chase performance by jumping into regional or country-specific funds. "That's not to say you don't need any emerging markets exposure," McDevitt says. "It's a good place to be, but I just worry that some investors might be chasing performance."

McDevitt recommends investing in a broadly-diversified world stock fund. In addition to having some direct exposure to emerging markets, many world stock funds own large multinational corporations such as Coca-Cola and McDonald's, which have substantial operations overseas. Such stock holdings provide a second layer of emerging markets exposure without tacking on the risk and volatility that can accompany investing in developing nations. "A multinational like Coke has a huge proportion of its business overseas, and a great proportion of that business is in emerging markets where a lot of that growth is coming from," McDevitt says. With a broad-based international stock fund, McDevitt says investors get access to fast-growing emerging markets profits, without chasing the performance of a specific country where market volatility and company valuations can fluctuate wildly.

[See Why You Shouldn't Chase Investing Trends.]

One broad-based fund McDevitt likes is American Funds EuroPacific Growth (symbol AEPGX). Aside from having "above-average" emerging-markets exposure, the fund leverages the expertise and best ideas of eight portfolio managers, who spread their picks across developed and developing countries alike. He suggests American Funds New World (NEWFX) for investors who are apprehensive about going whole-hog into emerging markets. "It's a really good hybrid fund that divides its portfolio between emerging markets companies and developed markets companies that do a substantial portion of their business in emerging markets," McDevitt says. "You can dip your toe in without going in all the way."