Emerging-Market Funds -- Proceed With Caution

Certain mutual funds allow investors in emerging markets to proceed cautiously.
By Stan Luxenberg ,

The news from the emerging markets is mostly positive. Economies are growing smartly, while debt levels remain under control. That has prompted investors to pour $20 billion into emerging market funds this year, according to Morningstar. Lately, the funds have lived up to expectations, returning 17.8% in the past year.

But investors who haven't yet tried the emerging markets should proceed cautiously. By many measures, stocks in the booming regions of Asia and Latin America are no longer cheap. The price-to-earnings ratio of emerging market funds is 14.1, about the same as the figure for U.S. domestic equity funds.

In the past, emerging markets stocks generally sold at big discounts. A decade ago, emerging stocks posted a P/E ratio of 10, about half the figure for the

S&P 500

. Investors argued that emerging markets should be cheap because many countries had suffered through a series of financial meltdowns in the 1990s.

The picture began to change after 2000 as governments in the developing world resolved to put their financial houses in order, reducing budget deficits and opening markets to foreign investments. That helped stocks to soar. During the past 10 years, emerging-markets funds have returned 13.9% annually, compared with 1.4% for domestic equity funds.

For all their success, the emerging markets today present considerable risks. Economies in Asia and Latin America still suffer from widespread poverty and regular cycles of booms and busts. The high volatility of developing markets was underlined in 2008 when emerging market funds lost 54.4%, trailing the S&P 500 by 17 percentage points.

Should you avoid the emerging markets altogether? Probably not. In the coming decade, much of the world's growth will come in the emerging markets. But it makes sense to focus on emerging markets funds that can limit risks. One of the steadiest performers is

Eaton Vance Parametric Tax-Managed Emerging Markets

(EITEX) - Get Report

, which has returned 19.3% annually for the past 10 years, outdoing 96% of competitors. The Eaton Vance portfolio managers have achieved their success by following an unusual strategy that employs rigid rules to ensure that the fund stays broadly diversified.

The managers start by dividing 44 emerging countries into tiers according to size. The top tier includes the biggest markets, such as Brazil and India. The portfolio managers allocate about 6% of assets to each of the big countries. In the second tier are countries such as Chile and Indonesia, which each get 3% of assets.

Under the system, many of the largest countries are underweighted compared to their allocation in standard benchmarks.

"The idea is to underweight the largest markets in order to avoid placing big bets on a few countries," says Brian Dillon, an Eaton Vance portfolio manager.

Why worry so much about overweighting big markets? Studying past performance, Eaton Vance determined that emerging countries often soar and sink. In 1994, the emerging markets with the biggest market capitalizations included Argentina and Malaysia. China was among the smallest markets. But since then, the roles have reversed as China has soared while the other countries fell in the standings. To avoid betting on an inflated market, Eaton Vance decided that it was necessary to underweight big markets.

As an additional precaution, the fund regularly rebalances to maintain its allocations. If stocks in a big country soar, the allocation can rise from 6% up to a set limit, such as 9%. Then the portfolio managers trim the holding back to the original allocation. Proceeds of any stock sales go to holdings in countries that have slipped below their target weightings. The aim is to systematically sell stocks in hot markets and buy shares in cold ones.

Another cautious way to invest is to buy a diversified international fund that holds only a small part of its assets in the emerging markets. An intriguing choice is

Baron International Growth

(BIGFX) - Get Report

, which has 22% of assets in Latin America and emerging Asia. Portfolio manager Michael Kass looks for shares that can grow for years because of long-term economic trends. To avoid trouble in the emerging markets, he stays away from companies that require lots of outside capital to operate. Such businesses can be caught short in downturns when investors retreat from buying stocks and bonds. He is also wary of the many companies in emerging markets that are controlled by governments.

"Some governments are primarily concerned about increasing employment--and not about serving the interests of shareholders," he says.

A favorite holding is

TOTVS

, a Brazilian maker of business software that serves fast-growing small companies. Kass says that the company is gaining new business because its products are substantially cheaper than software from the developed world.

Another holding is

Itau Unibanco

(ITUB) - Get Report

, a Brazilian bank. The bank should grow as demand soars for auto loans and home mortgages. Kass also likes

Wynn Macau

, a casino operator that is expanding as Chinese consumers spend more heavily on gambling.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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