This year's mutual-fund scoreboard highlights an interesting conundrum about investing in emerging markets.
Economies of big emerging-markets countries such as China, India and Russia have been growing much faster than the plodding U.S. economy. Yet if you own a fund that focuses on emerging-markets stocks, the chances are good that its performance this year has been lagging far behind the returns of the U.S.-stock funds in your portfolio.
How could that be?
The idea that a nation's economic performance is the main driver of returns in equities is one of several unfounded beliefs many investors have about the relative merits of developed and emerging markets. And this year, it has helped fuel strong demand for emerging-markets stock funds, which were one of the few areas in the equities fund world to see continued inflows during recent stock-market volatility.
If you're considering buying or selling an emerging-markets stock fund, it might be worth taking a closer look at some of these myths:
Myth 1: High stock valuations aren't a big deal in fast-growing economies.
The reality is that even in fast-growing nations it matters whether stocks are cheap or expensive relative to company fundamentals.
Investors have flocked to emerging markets for several years, expecting stronger economic growth there to produce stock returns well above those in the U.S. and Europe. As a result, emerging-markets stocks grew relatively expensive among global markets, based on valuation yardsticks such as price-to-earnings ratios.
The idea was that the high valuations weren't all that important. But they were. And investors discovered that, to their chagrin, when authorities in China, Brazil and other nations, concerned that their economies were overheating, tightened their money supplies and took other steps to temper growth and discourage speculation. Diversified emerging-markets stock funds were down 17.1% on average this year through Nov. 30, according to Thomson Reuters Corp.'s Lipper unit. And the stocks aren't expected to rally strongly anytime soon, according to a survey of forecasters by New York-based Heckman Global Advisors.
Meanwhile, in the U.S., investors bid stock prices sharply lower during late summer amid worries that the economy was headed for another recession. But when economic data continued to suggest that growth would remain positive, if sluggish, U.S. stocks began to look like a bargain.
Investors rushed back in. Through Nov. 30, the Standard & Poor's 500-stock index was down 0.9% in price and up 1.1% in total return including dividends.
Here's a silver lining: If you're considering adding emerging-markets funds to your portfolio, this might be an opportunity. "On a historical basis, emerging markets look pretty cheap today,'' says Michael Reynal, who heads the emerging-markets group at Principal Global Investors, Des Moines, Iowa.
Myth 2: Emerging-markets stocks are well-insulated from financial upheavals elsewhere in the world.
The thinking here is that emerging markets would march to their own beat simply because of their supercharged growth. That might have been true in the past. But today, stocks in most emerging nations trade closely in sync with those in New York and London. That's happened as companies in emerging nations have become bigger players on the world stage and as global flows of money have accelerated.
This year, as in developed markets, emerging-markets stocks were hit by fears about financial contagion spreading from Europe. In fact, they were hurt more than U.S. stocks. That's because the U.S., for all its economic and fiscal headwinds, still is viewed as the safest place to park money.
As you manage your portfolio allocations, think of emerging-markets stocks as akin to U.S. small-cap stocks in terms of risk, says Brian Gendreau, a veteran Wall Street money manager and market strategist for Cetera Financial Group, an El Segundo, Calif., advisory concern. "The more you allocate to emerging markets, the higher your expected return—and the higher the volatility of your portfolio,'' he says.
Myth 3: Emerging markets are a growth play.
Emerging-markets funds may indeed provide good growth if you invest smartly and have a long time horizon. But that's not the whole story. It also may be worth looking at emerging-markets funds that can provide income by focusing on bonds or dividend-paying stocks.
Eaton Vance Emerging Markets Local Income (EEIAX-News) invests in bonds of emerging nations, such as Malaysia and Indonesia, that are denominated in their local currencies. It is designed to provide income and diversification for U.S. dollar-based investors and it recently yielded about 4.7%. WisdomTree Emerging Markets Equity Income (DEM-News) is an exchange-traded fund that focuses on emerging-markets stocks with high dividend yields. It yields about 8.5%.
Some newer funds own mixes of emerging-markets stocks and bonds, similar to U.S.-focused balanced or allocation funds.
Strategic Latin America (SLATX-News), which has about $24 million in assets, holds a roughly equal mix of equities and bonds. Its performance was hurt recently by big declines in Latin American stocks and currencies. But over long periods, its share price should gyrate less than half as much as major U.S. stock indexes, says the fund's manager, Heiner Skaliks, making it possibly useful as a diversifier.
Pacific Investment Management Co. and Franklin Templeton Investments this year also launched funds that provide exposure to a range of emerging-markets assets, such as stocks and bonds. But these are still relatively untested.
Myth 4: Emerging-markets currencies will appreciate as the dollar continues its long-term decline.
That may prove true over many years, amplifying the returns for U.S. investors who buy into emerging markets, but it certainly wasn't the case in recent months. So far this year, emerging-markets currencies have generally weakened against the dollar; while the MSCI Emerging Market Index was down 14.8% in local currencies through Nov. 30, it was down 19.4% in dollar terms.
In September, worries about Europe's fiscal crisis sparked a rush back to the dollar, which investors viewed as a temporarily safer haven than some alternatives. The currencies of Brazil, Hungary, South Africa and Poland, among others, were savaged. The two Central European currencies trade closely in sync with the euro, because of close trading ties, and so slid as Europe's financial crisis flared. Brazil's widely traded currency may just have been an easy asset for big investors to sell when markets turned more choppy.
In calmer times, emerging-markets currencies could generate very attractive returns for U.S. investors, gaining against the dollar as the result of global financial imbalances, says Michael Cirami, who helps oversee emerging-markets funds at Eaton Vance Management. But sometimes they can significantly add to the volatility of emerging-markets funds, he cautions.
Myth 5: You can do even better by concentrating on just a few of the strongest emerging nations.
In recent years, investors have piled into exchange-traded funds that focus on individual nations, such as Brazil, Russia, India and China. iShares MSCI Brazil Index (EWZ-News), among the largest, has about $9 billion in assets.
But such ETFs offer much less diversification. And because they are highly liquid, or easy to trade in large amounts, their prices can be buffeted by abrupt shifts in global investor sentiment that may have little to do with longer-term fundamentals.
This year through Nov. 30, for example, WisdomTree India Earnings (EPI-News) is down 33% even though India's economy is likely to grow by better than 7% in both 2011 and 2012, according to Morgan Stanley Research.
Investors who want to capitalize on the growth prospects of emerging markets, but with less volatility, should consider funds that target broad regions or a wide range of emerging-markets countries, says Karin Anderson, a senior analyst at Morningstar. Among her recommendations is Vanguard MSCI Emerging Markets ETF (VWO-News), which holds about 900 stocks in nearly two dozen emerging countries.
Mr. Pollock is a writer in Ridgewood, N.J. Email him at email@example.com.