When It Comes to Emerging Markets Funds, Proceed With Caution

This is the second in a series of stories examining the outlook for international funds. Read the first article on European funds here.

Emerging markets funds seem to be ruling the world these days, but investors looking for international exposure need to know that these funds may provide a little too much of la vida loca for their liking.

After a dismal 2000, when the average emerging market fund lost 31.1%, 2001 so far has proven kind to emerging markets funds. With a year-to-date return of 3.57%, the category is the second top-performing group in Morningstar's ranking of international funds. The top performing category is Pacfic/Asia ex. Japan funds with a year-to-date return of 4.60%, while Latin American funds rank third, with a year-to-date return of 2.47%.

Performance of International Stock Funds*
Fund Category	Year-to-Date	One-Year	Three-Year	Five-Year
Pacific/Asia ex-Japan	4.60%	-25.46%	4.39%	-5.55%
Emerging Markets	3.57	-31.26	-3.13	-3.15
Latin America	2.47	-14.68	-1.82	4.54
Pacific/Asia	-1.34	-32.53	3.66	-4.15
Precious Metals	-2.07	-17.94	-9.35	-17.31
International Hybrid	-2.31	-4.30	5.82	5.69
Japan	-5.98	-34.35	5.95	-1.81
World	-6.37	-15.79	6.89	9.72
Foreign	-7.00	-21.40	6.02	7.34
Europe	-8.58	-20.59	6.00	11.55
*Data through Feb. 22, 2001. Source: Morningstar

Market watchers say a combination of factors, including the Federal Reserve's interest-rate easing and -- at least until recently -- the growing faith in a soft landing for the U.S. economy, has been giving a lift to emerging markets so far this year.

"Some of the Asian and Latin American markets started to go up dramatically after the Fed cut rates," says Leila Heckman, managing director of global asset allocation at Salomon Smith Barney. "It's been a little bit touch and go since then."

Interest-rate cuts in the U.S. help emerging markets because a buoyant U.S. economy is expected to help exports from developing countries. Since the beginning of the year, the region has seen strong flows from mutual funds -- fund tracker Lipper estimates that emerging markets funds received inflows of almost $400 million in January, compared with outflows of $250 million in December. The inflows in January were the highest since April 2000.

Top Emerging Market Funds Year to Date*
Fund Name	YTD Return	1-yr Return	3-yr Return	5-yr Return
(SHEMX Quote)Seligman Emerging Markets A	8.62	-42.25	-10.14	NA
(DRFMX Quote)Dreyfus Emerging Markets	8.61	-14.81	8.34	NA
(DEMAX Quote)Delaware Emerging Markets A	7.85	-22.41	-7.30	NA
Gartmore Emerging Markets B	6.96	NA	NA	NA
Kemper Emerging Markets Growth A	6.54	-24.66	-1.49	NA
William Blair Emerging Mkts Growth N	6.43	-32.00	NA	NA
Putnam Emerging Markets M	6.26	-35.85	-3.21	NA
(DPRMX Quote)Dreyfus Premier Emerging Markets R	6.09	-31.44	NA	NA
(PPEEX Quote)J.P. Morgan Emerging Markets Equity	5.95	-26.16	-5.24	-5.59
(LMEMX Quote)Legg Mason Emerging Markets Prim	5.75	-29.08	2.91	NA
*All Returns through Feb. 22, 2001. Source: Morningstar

Will It Continue?

That might sound like a bullish sign for emerging markets, but mutual fund analysts say it may be too soon to say whether or not the flows will be sustainable. Morningstar senior analyst William Rocco says fund flows into emerging markets are often the result of international fund managers moving into a region on a short-term basis.

"When the interest dries up because the macro picture changes, there are local problems, or aggressive European stocks get popular again, people leave," notes Rocco.

Others add that sentiment about emerging markets likely will become more solid once investors have a clearer picture of the U.S. economic outlook.

"Right now [this year's rise] looks very much like a short-term trade on liquidity, because we don't really have a sense of whether or not the U.S. economy has bottomed out," says Grace Pineda, senior portfolio manager of the (MADCX Quote)Merrill Lynch Developing Capital Markets fund.

Still, those managers like Pineda who are dedicated to emerging markets are picking their spots among the developing world's big names. A look at a chart of the top holdings of emerging markets funds shows them owning many of the same names:

Top Holdings of Emerging Market Equity Funds* by Percentage of Available Assets
Company	Number of Funds	% of Available Net Assets
Samsung Electronics	90	2.63%
Telefonos de Mexico ADR (TMX Quote)	81	2.41
China Telecom HK	84	1.94
Cheung Kong Holdings	44	1.44
Hutchison Whampoa	49	1.42
Korea Electric Power (KEP Quote)	59	1.13
SK Telecom (SKM Quote)	65	1.00
Grupo Financiero Banamex-Accival	47	0.96
Taiwan Semiconductor (TSM Quote)	62	0.96
Cemex	34	0.95
*Includes emerging market, Latin America and Asian funds. Source: Morningstar

The top holdings of the Merrill Lynch Developing Capital Markets fund as of the end of 2000 reflect several of the top 10 picks of other emerging market funds. The fund's most recent report for the fourth quarter of 2000 said the fund retained an overweight in media, telecommunications, banks and semiconductor equipment and products, with its largest positions in Mexico, Brazil, Taiwan, South Africa and South Korea. Among the fund's top 10 holdings were China Mobile Hong Kong, Telefonos de Mexico, Petroleo Brasileiro and Samsung Electronics. The fund is up 6.1% in the year to date, bouncing back from its drop of 29.7% in 2000.

The fund also reduced some of its exposure in Taiwan, Mexico, India and South Korea in favor of some oversold opportunities in the banking and wireless sectors of Greece, Russia and the Philippines. One of top holdings at the end of last year was Greek telecommunications company Hellenic Telecommunications (OTE Quote).

Meanwhile, Salomon Smith Barney's global asset allocation team is recommending an overweight allocation in the Eastern Europe, Middle East and Africa region, especially in Russia and South Africa, while also favoring Brazil, Malaysia, Singapore and South Korea. A recent report from the Salomon team cited Russia's inexpensive valuations compared with those of other emerging markets countries, along with a constructive GDP growth outlook.

The report also said that attractive valuations and a falling interest-rate environment should help Brazil, while competitive exchange rates should help boost the exports in the three aforementioned Asian countries.

Do Emerging Markets Belong in Your Portfolio?

Though many factors are indeed looking up for emerging markets, Morningstar's Rocco says that most individual investors need very little -- if any -- exposure to emerging markets funds. The analyst says only investors with very long timelines, say 15 to 20 years, and an iron stomach should think about investing in an emerging markets fund. Because these funds are notoriously volatile, an investor who needs the money in a few years might be sorely disappointed if the developing regions act up.

"The argument for emerging markets funds is that over time, these will be the fastest-growing economies in the world and that will translate into stock market gains," says Rocco. "Most of these funds aren't old enough to bear that out."

Indeed, many emerging market funds don't have track records going back five years, and very few have 10-year track records that investors can look at to see how the funds have fared in both good markets and bad.

Investors also might be smart to find out if the international funds they already own have a stake in emerging markets. If they have, that allocation alone might be enough to satisfy the wanderlust for investments in far-off lands.