Emerging Markets: Proceed With Caution
Meg Handley

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

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."

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.

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."

Use a multi-pronged approach.

The umbrella term "emerging markets" encompasses a highly diverse set of countries in varying stages of development. "Not all emerging markets are created equal," says Oliver Pursche, president of New York-based Gary Goldberg Financial Services. "There's a sizable difference in terms of risk expectations when investing in Brazil compared to Russia, or investing in India compared to the Middle East/North Africa region. They all kind of get lumped together as 'emerging markets' but there are sizable differences." While investing broadly is one way to capture a piece of the action in emerging markets, parsing out your investments among particular countries and sectors is another way to capitalize on growth in developing nations. As he does with his fund, GMG Defensive Beta (MPDAX), Pursche recommends using a combination of investments - including developing and developed market stocks, currencies and commodities - to hedge risk and attain diverse emerging markets exposure.

Pursche owns iShares MSCI Brazil Index (EWZ) and iPath MSCI India Index (INP), but has passed on direct country exposure to other well-performing emerging markets countries such as China. "The criterion is we need a politically stable area that encourages business and private industry and doesn't have a state-run type of business atmosphere," Pursche says. "That's the biggest reason we don't own China, for example. As much as they're growing at spectacular rates, we want to get the exposure to China in a different way."

When investing in specific country funds, Pursche advises investors to check out the financial regulatory system of the country first. "When you take country exposure, you're accepting the full risk of those markets and the geopolitical environment of that country," he says. That's the primary reason Pursche says he shies away from investing directly in China and the North African and Middle Eastern emerging markets. The political instability (think Egypt) and the still-developing financial institutions in those regions make other investment avenues more attractive.

Pursche also recommends supplementing specific emerging market country investments with exposure to U.S. multinational corporations. Like McDevitt, Pursche says many large domestic companies do a substantial portion of their business in emerging markets countries, giving investors that second layer of exposure to emerging markets countries and their expected growth.

Keep commodities in mind.

Finally, Pursche says investors should pay attention to commodities. If the inflation threat worsens, basics like food, raw materials and energy will be among a handful of sectors where profits continue to climb. "We own the very commodities that we think are going to appreciate and cause that inflation," he says. "Wheat, corn, sugar, and some of the energy sources in particular, coal and oil." With burgeoning demand from developed and developing nations or everything from coal to corn to palm oil, natural resource-rich countries such as Brazil, Russia, and Malaysia would benefit from spikes in commodity prices, as would investors with stakes in the items those countries produce.

While the variety of commodity investing options is growing, Pursche says the choices for long-term investors still aren't great. Many ETFs use complicated derivative methods or are designed for active day traders, but Pursche says investors can get a slice of commodity exposure with a broad-based fund such as PIMCO Commodity Real Return.

Keep a long-term outlook and remember the risks.

It might be tempting for investors to equate rapid GDP growth with robust market performance, but experts caution that many times, that's not the case. "Investors often [have] this assumption that strong equity performance or strong fixed-income performance follows strong GDP growth, and while we've seen that over the last decade, it doesn't always hold," McDevitt says. Over the short term, McDevitt and Pursche say GDP growth has a relatively low correlation to market performance. That means even if economies such as China and India continue to grow rapidly, the market might not react to those gains immediately. With that in mind, Pursche recommends investors take at least a three- to five-year outlook. "Emerging markets are very, very attractive for a number of reasons and in our opinion, a component in a well-diversified portfolio," Pursche says. "But it does require a greater risk appetite because [emerging markets] are undoubtedly going to be subject to more volatility."

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