Emerging-Market Funds Enter Danger Zone

NEW YORK (TheStreet) -- Emerging-market funds have been on fire. Van Eck Emerging Markets (GBFAX) has returned 108% this year, and Dreyfus Emerging Asia (DEAAX) is up 121%. Plenty of investors have been piling into emerging funds. But before you write a check, consider the fate of other high-flying funds. In nearly every case in the past, they have crashed soon after returning 100% in a year.

An episode of triple-digit returns occurred two years ago. With investors keen on the outlook for China, some Asian funds doubled. During the 12 months ending in October 2007, Dreyfus Greater China (DPCAX) soared 148%, while Aberdeen China Opportunities (GOPAX) jumped 145%. Then, with the credit crisis beginning to unfold, Asian stocks fell. For the year ending in October 2008, Dreyfus Greater China lost 72% of its value, and Aberdeen tumbled 64%.

Among the most dramatic market performances ever came in 1999 when 126 funds returned more than 100% for the year. Within months, nearly all the winners fell off a cliff.

Considering that history, should you stay away from red-hot emerging-markets funds altogether? Not necessarily. While emerging stocks could be rough for the next year, long-term investors have good reasons to begin gradually buying. By many measures, the outlook for emerging economies looks stronger than ever.

In the past, financial advisers viewed emerging-market stocks as shaky investments. Many countries in Latin America and Asia were plagued with heavy debt loads and sketchy financial regulation. In light of the extra risk, the price-to-earnings ratios of emerging shares were always lower than the multiple that investors paid for the S&P 500.

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