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Frontier Days for Investing in Emerging Markets


Growth in the Developing World



 Amy E Buttell Bookmark and Share

Correction: Several sharp-eyed readers noticed a misstatement in the article below. We suggested that a 40 percent increase for a mutual fund last year more than offset a 36 percent drop in the year before. The fund actually would have needed to increase by more than 40 percent to break even from the loss in 2008. For example, if a stock drops from $10 to $5, that’s a loss of 50 percent. To get back to $10, the stock price would need to increase by 100 percent.

Correction: Several sharp-eyed readers noticed a misstatement in the article below. We suggested that a 40 percent increase for a mutual fund last year more than offset a 36 percent drop in the year before. The fund actually would have needed to increase by more than 40 percent to break even from the loss in 2008. For example, if a stock drops from $10 to $5, that’s a loss of 50 percent. To get back to $10, the stock price would need to increase by 100 percent.
Editor’s note: This month we present the results of this year’s Mutual Fund Survey, in which BetterInvesting readers identified their top three fund holdings. The mutual funds most widely held by survey participants are listed below.
   
In the first part of this article, Amy Buttell discusses growing options for investors interested in emerging and frontier markets. This annual survey is nonscientific and isn’t meant to represent BetterInvesting members as a whole. Funds are mentioned in this article only for educational purposes. No investment recommendation is intended.


Before the Great Recession, emerging markets were like dessert — a nice addition to a portfolio, but hardly necessary. But as domestic growth remains sluggish while the global economy emerges from the doldrums, emerging markets may be winning themselves a place in the main course, with long-term projected growth rates likely to exceed those of the developed world.




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There’s still a lot to be said for domestic and developed world markets. Stocks of the world’s largest companies trade on exchanges in these regions, where regulation and accounting standards ensure much more transparency and accountability than in developing markets. But what emerging markets have, in spades, is the promise of growth. Many emerging economies sidestepped the Great Recession, and their markets were on a tear not just during 2009 but also for much of the decade.
   
Many of these countries are developing both economically and politically. The emergence of the Group of 20 Nations in the financial crisis, supplanting the Group of 8 Nations, gives emerging market nations, especially the largest and fastest-growing ones, access to the international stage and much more influence in political and economic decision-making at the highest levels. In fact, the National Intelligence Council, the center of strategic thinking within the U.S. government, predicts an  “unprecedented” shift of political and economic power from West to East by 2025.
   
What this means for investors is lots of opportunities in emerging markets, not only in larger economies such as the BRIC nations — Brazil, Russia, India and China — but also in their smaller siblings, known as frontier markets, the true Wild West of investing. The best ways to access these markets are still mutual funds and exchange-traded funds, although more emerging market companies are becoming listed as American Depositary Receipts.
   
“Today’s emerging markets are not your grandfather’s emerging markets,” says Rob Lutts, chief investment officer at Cabot Money Management in Salem, Mass. “Meaning, the world is changing and many of the countries that are in emerging market indexes really don’t deserve to be there. Many of the largest players have matured and are successful in economic development, stronger internationally and have more experience in running their governments. What all this means for average investors is that they can feel a little more comfortable having a larger allocation to this space, because it isn’t as risky as it used to be.”

Emerging Versus Frontier Markets

Emerging economies are more developed than they were in the past but lack the sophisticated financial markets and political stability of developed regions. The MSCI Emerging Markets Index (see table, page 33) includes 22 countries in Central and South America, Africa, the Middle East, Asia, Central and Eastern Europe and the Commonwealth of Independent States (former satellites of the former Soviet Union). The infamous BRIC nations are part of this index.
   
Frontier markets, on the other hand, are smaller, with more potential economic and political instability but with a higher risk-reward potential. The MSCI Frontier Markets Index (table, above) comprises 25 countries in the same areas as the MSCI Emerging Index, markets such as Argentina, Kazakhstan, Nigeria, Oman and Pakistan that are much less well-known to U.S. investors.
   
“Frontier markets are really the children of the financial markets,” says Christian Magoon, president of Claymore Securities, a sponsor of emerging and frontier market ETFs in Lisle, Ill. “There is a lot more volatility associated with them. A lot of the risks include everything from social unrest to political instability to generally a large government ownership of infrastructure and services in the country.
   
“But the reason the frontier markets are of interest to investors is that frontier countries have a historically higher rate of return than emerging market countries. They have more volatility, or risk, associated with them. But over the long term, they’ve had higher returns and they’ve also had a lower correlation to developed markets than emerging markets.”
   
Overall, emerging markets, including frontier markets, are benefiting from their ownership of commodities and rising internal consumer demand.
   
“The look of emerging markets is very similar to the look and makeup of the United States around the turn of the 20th century,” says Ronald D. Weiner, president and CEO of RDM Financial Group in Westport, Conn. “Then, we had positive cash flows in the Treasury. We had strong family units, people were coming from the farms and moving into the cities. But more importantly, they hungered for something better, and that’s what we are seeing happening in China, in India and in many emerging market countries.”

Challenges to Fundamental Investing

Inflation and currency issues are two important factors to consider when pondering investing in emerging markets. Higher inflation tends to be good for emerging market countries that are rich in commodities and natural resources, because their economies thrive when there’s commodity-driven inflation. On the other hand, these countries tend to suffer from higher internal inflation than developed countries, which can hamper economic growth, Magoon says.
   
A weaker dollar tends to drive assets into emerging markets, which can create asset bubbles. Investors need to consider this when investing in this area. Your returns from investing overseas, whether in the developed or developing world, will be stronger or weaker based on currency issues that have nothing to do with the underlying fundamentals of the companies in your mutual funds or ETFs because of how local currencies fluctuate against the U.S. dollar.
   
Mutual fund and ETF managers have a choice in whether to hedge their exposure to foreign currencies versus the U.S. dollar. Hedging can almost completely remove the effects of currency fluctuations, so funds or ETFs that hedge will have returns more representative of their underlying investments. But when other currencies are appreciating against the U.S. dollar, which was the case in 2009, unhedged funds will show better returns.
   
Not hedging for foreign currency exposure in your investments is one way to maintain the purchasing power of your investments, potentially helping you counter any increase in U.S. inflation rates that may result from large U.S. government budget deficits,
says Stuart Kruse, founder of Kruse Asset Management in Chicago.
   
“For a U.S. investor, if you invest overseas, especially in the commodity areas, you get diversification,” he says. “Another benefit is that you’re not paid in U.S. dollars, which will help you in terms of dealing with inflation.”

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Mutual Funds or ETFs?

If you’re looking to bolster your emerging or frontier market exposure, the most convenient ways are through mutual funds and ETFs. If your portfolio is less than $50,000, you might want to start with a single broad-based ETF or mutual fund and build out from there, adding another fund or ETF or two as your assets grow to become more diversified.
   
Many investors start with an ETF or mutual fund tracking the MSCI Emerging Markets index. “If you want broad exposure to emerging markets and just want to stick your toe in the water, that may be the best place to start,” Kruse says. As you save more, you can diversify by adding another ETF or mutual fund that focuses in a different area from your original investment. Be careful not to put too much into frontier markets or into funds or ETFs focused on individual countries because they’re quite risky, says Eduardo Ramos, CPA, a financial adviser and founder of Freedom Advisory in San Juan, Puerto Rico, and Chicago.
   
Ramos prefers actively managed funds because a good, experienced manager can add returns. Also, indexes include good and bad companies, and the bad companies can dilute your returns, he adds. Actively managed funds specializing in emerging and frontier markets tend to carry high expense ratios, especially when compared with mutual funds that focus on the United States. It’s more expensive to follow companies in those markets and to employ analysts on the ground.
   
Although many investors focus on emerging and frontier stock markets, there’s money to be made in bond markets, Weiner says. But financial problems in emerging market countries such as Greece and in developed countries such as Ireland and Spain have clouded the picture for foreign corporate and sovereign debt, so investors might want to hold back on this idea for now, he adds.
   
It’s pretty easy to find diversified ETFs and actively managed mutual funds related to international bond funds. More-specialized funds are also available but are more risky. Just as with emerging and frontier market stock funds, bond funds are also risky. A government or particular company may default on its bonds, or its credit rating could be lowered. International bond values are also highly dependent on currency issues.

Emerging Market Allocations

As you review your portfolio and consider tweaking asset allocations in 2010, study what you’re allocating to emerging and frontier markets and decide whether it’s time to bump up those percentages. U.S. investors tend to overweight U.S. companies in their asset allocations, which can cause them to miss better opportunities elsewhere, Kruse says.
   
“You basically need to take a look at your risk level,” he says, “and the more risk you can take on, the more you can go toward emerging markets. But it should still probably be a minority position in your overall international exposure.” Kruse is slanting his clients’ exposure along the lines of 60 percent domestic, 40 percent international; within the international segment, 70 percent developed markets and 30 percent emerging markets is a workable asset allocation.
   
Base asset allocations on an assessment of your risk-reward profile and overall investment goals, rather than on a desire to make up for losses experienced in the market meltdown of 2007-08, Ramos says.
   
“People are trying to catch up for whatever returns they have lost,” he says. “They shouldn’t overallocate into emerging markets, even as attractive as they seem. You have to have an asset allocation process based on the risk level of each individual.” The firm’s allocation to emerging markets is typically around 12 percent, ranging anywhere from 6 percent to 18 percent.
   
Another way to access the growth inherent in emerging and frontier markets is to invest in U.S. and European multinational corporations that do business in those countries, Weiner says. “If you invest in multinationals in your developing-world portfolio, there are lots of strong companies that sell to those countries,” he says. “For example, Intel derives 80 percent of its earnings from overseas, and there are plenty of other companies that are involved, from Philip Morris to Caterpillar. Foreign markets are more and more important to those companies.”

Bond Funds Break Through

Investors’ desire for higher yields and their fear of inflation are evident in BetterInvesting’s 2010 Top 10 Mutual Fund Survey. For the first time, two bond funds join nine stock funds in this year’s survey. Although bond funds aren’t new to the survey, this is the first year that two of them made the cut, along with many familiar stock fund names from previous surveys.
   
The two bond funds — Vanguard High-Yield Corporate and Vanguard Inflation-Protected Securities — join three other Vanguard stock funds, two Dodge & Cox funds, two Fidelity funds and two American funds. Not many surprises here. There are two international funds, two index funds, one blend fund, one mid-capitalization stock fund and three large-cap actively managed funds.
   
Each of the four fund families represented in the survey carry a reputation for low costs, an important feature for savvy investors who are looking to maximize returns (although the two American Funds offerings carry sales loads). The nine actively managed funds in the survey all have distinctive investment strategies and strong long-term performance records, two reasons these funds are popular with both BetterInvesting readers and investors around the country.

   
    Vanguard Total Stock Market
    Manager: Gerard C. O’Reilly
    Ticker Symbol: VTSMX
    Style: Large Blend
    Minimum Purchase: $3,000


One of five Vanguard funds in the 2010 survey, Vanguard Total Stock Market is one of the cheapest core funds around, a handy proxy for the entire U.S. stock market. As such, it has had its ups and downs: In 2008 it was down a brutal 37 percent but up 30 percent in 2009 as of Dec. 24. Guided by veteran manager Gerard O’Reilly, the fund endeavors to track the MSCI U.S. Broad Market index, holding 3,400 large, mid- and small-cap stocks. Even so, it’s pretty heavily weighted toward large stocks, although less so than its sibling Vanguard 500 Index Fund.

   
    Vanguard 500 Index
    Manager: Michael Buek
    Ticker Symbol: VFINX
    Style: Large Blend
    Minimum Purchase: $3,000

If you’re most comfortable investing in the behemoths of corporate America, Vanguard 500 Index is a worthy choice. It tracks the Standard & Poor’s 500 index, which is composed of the 500 largest companies in the United States by market capitalization. This fund remains a favorite of BetterInvesting members, appearing in every survey since its inception in 2001. It carries low costs and has an experienced manager who tries to keep transaction costs as low as possible.

   
    Vanguard High-Yield Corporate Bond Fund
    Manager: Michael L. Hong
    Ticker Symbol: VWEHX
    Style: High-Yield Bond
    Minimum Purchase: $3,000

A newcomer to the survey, the fund is gaining assets at a rapid clip, courtesy of its scorching gains in the past year. The fund returned an eye-popping 39 percent in 2009 through Dec. 24. Such performance likely won’t be sustained into 2010, said Vanguard in October in cautioning investors not to let short-term returns guide long-term investment decisions. Manager Michael Hong is new to the fund — he took over in June 2008 — but he’s highly experienced in the field and assisted by a team of credit analysts.

   
    Dodge & Cox International
    Manager: Team
    Ticker Symbol: DODFX
    Style: Foreign Large Value
    Minimum Purchase: $2,500

One of two international funds and two Dodge & Cox Funds in the survey this year, Dodge & Cox International recovered in 2009 from a significant stumble in 2008. Many international funds had bad years, but 2008 was a particularly bad one for Dodge & Cox, a boutique fund shop with a stellar reputation. The fund’s black eye in 2008 was largely caused by an untimely bet on financials that landed it near the bottom of its peer group. The results in 2009 have vindicated the fund company, as the fund was up 47.9 percent for the year to date, ranking fifth in its category, Morningstar reports.

   
    Vanguard Wellington Fund
    Manager: Edward P. Bousa and John C. Keogh
    Ticker Symbol: VWELX
    Style: Moderate Allocation
    Minimum Purchase: $10,000

Vanguard Wellington invests 60 percent of its assets in undervalued companies that pay dividends and 40 percent in investment-grade corporate bonds. The moderate-allocation fund has a low turnover rate, with an average annual five-year rate of 24 percent. That reflects management’s buy-and-hold philosophy. Wellington Fund’s investment minimum is higher than the traditional Vanguard minimum of $3,000, but the fund company frequently raises investment minimums to slow asset flows. Its expense ratio of 0.29 percent is one of the lowest in the category.

   
    Vanguard Inflation-Protected Securities
    Manager: John Hollyer and Kenneth Volpert
    Ticker Symbol: VIPSX
    Style: Inflation-Protected Bond
    Minimum Purchase: $3,000

Inflation could hardly be lower, but that doesn’t mean there isn’t a role for an inflation-protected bond fund in your portfolio. Many people consider inflation a threat in the coming years, and this fund, making its first appearance in the survey, is designed to protect investors from it and provide current income. To achieve the fund’s objective, management invests at least 80 percent of its assets in inflation-indexed bonds issued by the U.S. government. The fund comes at a dirt-cheap price, with an expense ratio of 0.25 percent.

   
    Fidelity Low-Priced Stock
    Manager: Joel Tillinghast
    Ticker Symbol: FLPSX
    Style: Mid-Cap Blend
    Minimum Purchase: $2,500

Despite concerns that the fund’s large size would crimp manager Joel Tillinghast’s style, the fund continues to deliver superior returns. For the year to date, the fund was up 40.1 percent, more than offsetting a 36.2 percent drop in 2008. Managing a fund of this size is no easy feat, especially when its focus is small- and mid-cap stocks. To achieve high returns, Tillinghast invests in a wide range of stocks — 863 as of July 31, 2009. Of those companies, 44.2 percent are mid-cap, 25.5 percent small-cap and 9.6 percent micro-cap. The fund’s expense ratio of 0.99 percent is higher than that of some of its peers, but it’s decent considering management’s long-term track record.

   
    American Funds EuroPacific Growth (Class A)
    Manager: Team
    Ticker Symbol: AEPGX
    Style: Foreign Large Blend
    Minimum Purchase: $250

This fund focuses on large international companies. Because of American Funds’ approach to management, EuroPacific Growth’s $93.7 billion in assets are divided among eight managers, each of whom manage a slice of the fund’s assets in line with its overall investment objectives. The fund has been quite successful, especially in the past two years, when it flourished in both bear and bull markets. That’s a rare accomplishment. The fund’s only drawback is its sales-load fee structure, under which most investors purchase fund shares through investment advisers. You may be able to find a no-load version in a company 401(k), however.

   
    Dodge & Cox Stock
    Manager: Team
    Ticker Symbol: DODGX
    Style: Large Value   
    Minimum Purchase: $2,500

Dodge & Cox Stock had a very tough 2008. In 2009 the fund rebounded smartly from its worse-than-usual showing, gaining 32.8 percent for the year to date and ranking 14th in Morningstar’s large-blend category. Despite the beating the fund took in 2008, management resolved to stick to its tried and true philosophy of finding undervalued companies by digging deep into balance sheets and statements of cash flow to separate the treasure from the trash. The fund’s low expense ratio of 0.52 percent is another reason to give it a second look.

   
    American Funds Growth Fund of America (Class A)
    Manager: Team
    Ticker Symbol: AGTHX
    Style: Large Growth
    Minimum Purchase: $250

This fund has appeared several times in the survey, and for good reason: It has a strong long-term track record, seasoned management team and disciplined investment strategy. Management is divided among a group of experienced investment managers, many of whom spend their entire careers at the fund family. The fund’s expense ratio is a reasonable 0.76 percent, but as with the other funds in the family, it carries a sales load that can trim your returns.

   
    Fidelity Contrafund
    Manager: William Danoff
    Ticker Symbol: FCNTX
    Style: Large Growth
    Minimum Purchase: $2,500

Fidelity Contrafund is having a bit of an off year, although its long-term record is strong. As at other large funds — this one has $61.8 billion in assets — it isn’t easy to turn the ship around. Manager Will Danoff has been cautious about the economic recovery, and that caution is reflected in the fund’s returns. Its performance has beaten the S&P 500 but lags many of his peers. Still, the fund’s long-term record, low expenses and buy-and-hold approach are all reasons to stick with the fund or consider it as an option if you’re shopping for a large-growth fund to fill a gap in your portfolio.


Freelance writer Amy E. Buttell of Erie, Pa., covers mutual funds for BetterInvesting. She’s also the author of the second edition of the association’s Mutual Fund Handbook.


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