Seeking a Portfolio Boost in Emerging Markets

Your portfolio could benefit from emerging-market exposure—in moderation.

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When Americans talk about investing, they usually mean investing in U.S. assets. Of course, there is a wide world of investment opportunity beyond U.S. shores, much of it in so-called emerging markets, whose economies tend to grow faster than the developed world's for a variety of reasons. The popular Vanguard Emerging Markets ETF (symbol: VWO), which references the widely consulted MSCI Emerging Markets Index of 21 countries, is up 58 percent since the fund's March 2005 inception. The iShares MSCI EAFE Index fund (EFA), a proxy for developed-world stocks, is down about 10 percent over the same period.

Over the long term, then, the typical U.S. investor would do well to have some exposure to the world's developing economies, and there are lots of ways to get it. Among mutual funds, just to name two, Lazard's Emerging Markets Equity (LZEMX) and Oppenheimer's Developing Markets (ODMAX) "are particularly good for broad-base emerging-market funds," says Morningstar analyst William Rocco. Both have outperformed their Morningstar category in recent years, and both charge annual expenses that are below their category averages.

[See Top-Rated Emerging Market ETFs.]

But before you go shopping for emerging-market opportunities, some caveats. First, Rocco advises, look at your existing portfolio, which may already have more emerging-market exposure than you realize. A typical large-cap international fund might be 20 percent or more invested in emerging-market assets, he says.

If you want more emerging-market exposure, be sure you have two other important things: a stomach for volatility and a long time horizon. With fund investments in general, you should have a five- to 10-year time horizon, say many advisers. "With [emerging-market] funds it should be even longer," says Rocco. "This is not a place for a 25- or 30-year-old to put their housing down-payment money."

And remember that diversification is as important abroad as it is at home. "Individual investors should not be trying to pick a particular region, but rather should seek out a broad-based fund that has freedom to invest throughout the developing world," says Rocco. "It's pretty challenging for an individual investor to say 'I think India is going to do better do better than China,' or anything like that."

Also, as with any investment, be aware of the risks. Political risk, for example, might include opaque regulations, corruption, and unexpected regulatory changes. For example: Malaysia's imposition of capital controls in early 1994 set off a sharp decline in equity prices throughout Southeast Asia.

[See Should Investors Tread Into New Frontiers?]

Other risks are worth watching as well, including the value of local currencies. Currency risk is the danger that the currency of the foreign economy you're investing in will weaken, offsetting any local-currency gains in the stocks themselves. (If, in addition, the stocks themselves fall, you get hit two ways.)

Currency swings can have a huge impact—for better or worse—on investment outcomes. IndexUniverse analyst Paul Baiocchi showed on his blog recently how investors in several BRIC (Brazil, Russia, India, China) ETFs could have more or less halved their losses during the past year by hedging their currency exposure. There are no currency-hedged ETFs for the BRICs, as Baiocchi notes, but there are for other markets—the DBX MSCI Emerging Markets Hedged Equity (DBEM), for example.

Other factors to consider: Developing economies tend to be relatively small, making them more vulnerable to significant flows of foreign capital. Many investors learned this the hard way during "Asian contagion," sparked by Thailand's devaluation in July 1997.

"The most volatile funds over extended periods of time are Latin American funds, energy funds, and, not too far behind, broader emerging-market funds," says Rocco.

[See Top-Rated World Stock Funds.]

One argument in favor of emerging markets has been the idea of "decoupling"—that is, the shrinking reliance of developing economies on exports to the developed world, and economic growth based increasingly on domestic and regional demand. That, along with improved corporate governance and government finances, supposedly makes emerging markets less risky than they used to be.