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Don't Lose Your Shirt in Emerging Markets

This lucrative fund trend could be nearing its zenith.

Few investments have been as hot in the past few years as emerging-markets funds.

Consider that since the start of 2004, a $10,000 investment in

(DFEVX) - Get DFA Emerging Markets Value I Report

DFA Emerging Markets Value (DFEVX) grew to nearly $25,000. The same investment in the

(FEMKX) - Get Fidelity Emerging Markets Report

Fidelity Emerging Markets (FEMKX) and

(ETGIX) - Get Eaton Vance Greater India A Report

Eaton Vance Greater India (ETGIX) funds would have grown to $22,600 and $24,500, respectively.

But are they getting too hot to handle?

They may be, says Khiem Do, a strategist for Baring Asset Management in Hong Kong and the manager of the exchange-traded

Asia Pacific Fund


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"We have been taking some profits in China as some of the names have been getting a little expensive," Do says. He adds that India, another strong emerging market, is also getting more expensive.

After riding the Chinese and Indian stock markets to big gains last year, Do isstarting to sell some of his Chinese investments. His fund, of course, requires him to stick to the region. But now he's putting his money to work in places there where he sees better value, such as Korea, Thailand and Malaysia.

Do, who has beaten his Lipper averages over the past three and five years, is now putting his money to work where he sees better value in the region, such as Korea, Thailand and Malaysia. When an experienced manager close to the action starts to get worried about market valuations, it's worth taking notice.

Another sign that the emerging markets may be overheating comes from recent data from the Financial Research Corp., which tracks U.S. mutual fund sales. FRC's latest data show U.S. investors were jumping on the Asia-Pacific bandwagon in increasing numbers last year -- even after the funds already had posted several years of 20%-plus gains.

Net sales of Asia-Pacific funds more than doubled in 2006 to $7.3 billion, including nearly $1.3 billion in December alone. Investors also pumped $12 billion in other emerging-markets funds during the year. Retail investors, as usual, tend to be late to get in on the action. People weren't pouring money into these funds back in 2001 and 2002, before the big gains.

The strongest arguments for investing in Asia in recent years have been that the economies there are booming and the shares were relatively cheap. But Bijal Shah, chief market strategist at SG Securities in London, points out that Indian stocks are no longer inexpensive.

In fact, "India's valuations are in stratospheric territory," he says. "A bubble is forming." Even though company earnings have soared over the past four years, Shah says, investors today are willing to pay much more for each dollar of earnings in the hope that this growth will keep going. "This same logic applied in the U.S. in the 1999 and 1987 bubble years."

Shah also questions whether emerging stock markets are really the play on those countries' domestic growth that investors think they are. By his estimation, they are simply another investment that rises and falls on the actions and habits of the U.S. consumer.

For example, he compared changes in valuation multiples in the main emerging equity markets over the last four years with changes in U.S. retail sales over the same period. And guess what? They track each other almost identically. In other words, for all the talk of the new Chinese and Indian consumer, what's happening in their stock markets still depends on what's happening at your local Wal-Mart.

"Many commentators believe that the equity markets of the larger emerging economies such as Brazil, India, Russia, and China offer fantastic long-term prospects," he writes. "But the reality is that these emerging equity markets are just a play on the U.S. consumer cycle."

There's probably no need to panic, but it's still a good idea to view emerging markets more cautiously than many people have to date. The boom there may yet continue, but the balance of risk and reward right now doesn't look as compelling as it has in recent years.

In keeping with TSC's editorial policy, Brett Arends doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Arends takes a critical look inside mutual funds and the personal finance industry in a twice-weekly column that ranges from investment advice for the general reader to the industry's latest scoop. Prior to joining in 2006, he worked for more than two years at the Boston Herald, where he revived the paper's well-known 'On State Street' finance column and was part of a team that won two SABEW awards in 2005. He had previously written for the Daily Telegraph and Daily Mail newspapers in London, the magazine Private Eye, and for Global Agenda, the official magazine of the World Economic Summit in Davos, Switzerland. Arends has also written a book on sports 'futures' betting.