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Viewpoint: Despite Earthquakes, Riots and Defaults, Emerging Markets Funds Might Be Worth the Risk

Investors are showing a willingness to take more and more risks in the U.S. markets anyway.

The third quarter was pretty dismal for emerging markets as earthquakes shook Turkey and Taiwan, political riots devastated Indonesia, and Ecuador defaulted on its Brady bonds. And mutual fund returns show it. The average diversified emerging-markets fund was down more than 6% last quarter.

The dip wasn't anywhere near enough to wipe out the first half's impressive gains. Year to date, the group is still up 26.2%. But the quarter was probably enough to remind investors of the Asian contagion that infected emerging markets a year ago last summer, and the Tequila crisis in 1994, when the devaluation of the Mexican peso gave the whole region a hangover.

So I haven't really been surprised that investors aren't flocking to emerging-markets funds -- at least not individual investors. But lately I've started to wonder whether they should.

After all, if U.S. investors were the sort to be scared off by allegations of questionable accounting, roller-coaster stock prices and the possibility that a single issue could lose nearly 20% of its value in a week, why wouldn't they own stocks like



? (And plenty do; the stock is on several of


funds' top-10 holdings lists.) The same can be said for more than one high-tech highflier.

Unfair comparisons? OK, I'm aware of the difference between the "new economy" and an emerging one; between the potential in the technological revolution and the potential for a political one. Still, if you ask me, investors are happily taking on more and bigger risks every day in the U.S. market -- so why not overseas?

Not that I'm not big on outsized risks -- here or abroad. So when I decided to ask where the opportunities were overseas, I talked to folks who, for the most part, skirted the third-quarter disaster in emerging markets. Three of the fund managers I spoke to have vastly different strategies for approaching emerging markets. Nonetheless, a few common themes -- pardon the expression -- emerged:

  • Growth opportunities in many markets abound, while valuations are universally low.
  • In the long term, strong global growth will benefit the manufacturing- and commodities-based businesses that dominate emerging markets.
  • In the short term, Y2K concerns cannot be dismissed.

Chris Alderson, head of emerging markets for

Rowe Price-Fleming

, manages the

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T. Rowe Price Emerging Markets Stock fund, down just 2.4% for the quarter and up 30% for the year. Alderson picks stocks, not regions, and his focus is growth. Not surprisingly, his two favorite sectors are telecom and tech, accounting for 50% of the fund's portfolio. That bias kept him underweight in Latin America, last quarter's land mine. "Bottom line," says Alderson, without a hint of irony, "there aren't that many growth companies in Latin America."

Instead, Alderson has committed 15% of his portfolio to India, where a highly skilled labor force can iron out software wrinkles or tackle a design flaw at a 20% discount to labor costs in the West. Alderson particularly likes

Zee Telefilms

, a media and satellite TV company, and

Pentafour Software

. Taiwan, now an outsourcing Mecca for laptop manufacturers like


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, claims 11% of Alderson's portfolio.

By contrast, Daniel Beneat, manager of the

Dreyfus Premier Emerging Markets

fund (down just 1.6% for the third quarter, up 49% for the year), is tempted by the value in Latin America, particularly in Brazil and Mexico. Beneat favors Brazilian paper manufacturer

Ara Cruz

, a low-cost producer that he thinks will experience pricing power as global growth picks up. Beneat and Alderson agree on Taiwan's bright prospects. Beneat gloats about the 165% gain so far this year in his favorite,

Taiwan Semiconductor


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Dreyfus Premier Technology Growth fund also holds the stock. "We like it firm-wide," he says.

A team of experts at

State Street Global Advisors

takes a far different approach to emerging markets but achieves similar results. The

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SSgA Emerging Markets fund is down just 1.7% for the third quarter and up 31% for the year. "We don't take large, aggressive bets in terms of regions or stocks," says George Hoguet, head of State Street's active emerging-markets team. The fund is a group project, and relies heavily on a quantitative model -- so it shouldn't be a big deal that it lost manager Josh Feuerman last month. Brad Aham has taken over day-to-day management, with input from Hoguet and other colleagues.

The fund's valuation discipline has led it to lighten up on Greece, a market that has seen stocks more than double so far this year. Going forward, State Street likes fast-growing Korea, commodities-rich South Africa and Israel, which boasts a solid

technology sector.

The thorniest issue for emerging markets is the Y2K bugaboo. What would be a 12% weighting in emerging markets for financial planner Mary Malgoire of

The Family Firm

in Bethesda, Md., is now zero because of Y2K worries. "We just can't know" how prepared emerging-markets companies are, she reasons.

Dreyfus' Beneat, like most fund managers, has reviewed his holdings extensively to make sure his companies are Y2K compliant. But even he concedes that people have a right to be nervous.

"I only own large-cap banks and the larger telecom stocks," he says. But the bigger danger for investors is being out of the market, if and when the New Year turns up fewer problems than expected. "You can't afford to miss a rally in this asset class. When the money comes in, these stocks pop -- 17% in a day sometimes."

If I haven't convinced you yet to load up on emerging markets -- good. That's not my intent. Emerging markets account for only about 4% of the world's investable securities -- and that's about all you need in a diversified portfolio. You can quibble about whether to buy before or after the Y2K phenomenon plays itself out. But for long-term investors, it really doesn't matter.

Anne Kates Smith is a senior editor at U.S. News & World Report in Washington. At time of publication, Smith had no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds.