Rocco is generally not enthusiastic about regional or single-country emerging markets funds. “They may be more volatile than diversified funds,” he says. The Asian financial crisis of 1997–1998 punished regional stock funds there, while Latin American funds have posted losses in five of the past 12 years, including a 59% slide in 2008.
Do regional emerging markets funds ever make sense? “Perhaps,” says Rocco, “if you have a large portfolio that already includes domestic stock funds, an international fund for developed markets, and a diversified emerging markets fund. In that situation, you might invest a small portion of your portfolio in a region or country that you believe will do better than the rest of the world. But you should treat a regional or single-country emerging markets fund like a stock that might do very well or very poorly.”
Emerging markets bond funds. Government and corporations in emerging markets may borrow money via bond issues; several mutual funds hold these securities. These funds offer generous yields (the category average is now around 5%, compared with domestic bond funds, which average 4.42%) as well as the chance for capital appreciation.
Over the past 10 years, emerging markets bond funds have returned 11.07% a year, which was higher than the average for diversified emerging markets stock funds. They’ve been less risky than the stock funds, too: In 2008, when emerging markets stock funds lost nearly 55%, the bond funds lost only 17.64%.
Even though emerging markets bonds have been strong lately, Johnson is unmoved. “With any bonds you have exposure to interest rates. If rates rise from today’s low levels, your bonds will lose value. With emerging markets bonds, prices may fall rapidly if there’s any sign of political unrest.” Rocco agrees that emerging markets bond funds tend to be more volatile than other types of bond funds, but says they might be suitable for some portfolios. “Just as some investors might want to hold an emerging markets stock fund as part of their equity allocation, so an emerging markets bond fund might fit into a fixed-income allocation,” he says. “Along with the volatility, there is the chance for substantial returns.”
Playing the Percentages
Many observers like the growth prospects for emerging markets but caution against overloading there because of the risk of downward swings. Johnson says his clients typically invest 10% of their portfolios in emerging markets. “I like inexpensive, well-diversified funds,” he says. “If you buy one country or one region, you might be too dependent on one commodity or too exposed to a local economic problem.”
Apex’s Baker recently recommended to Marlene Blaise, 41, a cardiologist in Alpharetta, Georgia, that she invest 3% of her portfolio in Vanguard Emerging Markets Index Fund (VEIEX). The Vanguard fund’s low expense ratio is the key to its appeal: It charges 0.40% of assets per year, while the average diversified emerging markets fund charges 1.77% a year. “The cost advantage of this Vanguard index fund is so great,” says Baker, “that other funds will have a difficult time matching its performance over the long term. As for asset allocation, Baker says that Blaise’s 3% commitment is moderate for his clients. “Some conservative clients have no emerging markets at all, while others have as much as 5%. Down the road, I might suggest that Blaise increase her emerging markets allocation to 5%, perhaps by adding a country-specific fund focused in Brazil, India, or China.”
Blaise believes that venturing into an emerging markets fund will be worthwhile. “Emerging markets have tremendous growth potential,” she says, “probably more than developed markets have now. In addition, diversifying your investments makes sense.”
By diversifying into asset classes such as emerging markets, which don’t always move in sync with U.S. stocks, you may get valuable noncorrelation. In 2007, for example, the average U.S. stock fund returned less than 7% while diversified emerging markets funds returned nearly 37%, on average.