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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