Investing in emerging markets doesn't have to involve high risk.
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By Russel Kinnel | 07-16-12 | 06:00 AM | Email Article

Emerging markets are an intriguing challenge for managers and fund investors alike. Today these markets offer more than a way to add some zip to your portfolio. They also offer a way to move away from the debt-burdened economies and the brunt of a possible Greek exit from the euro.

Russel Kinnel is director of manager research for Morningstar and editor of Morningstar® FundInvestor℠, a monthly newsletter.

Thus, they may deserve a bigger part of your portfolio. As emerging markets have gotten more sophisticated, a greater variety of strategies and approaches are now available in mutual fund form. There are bond funds investing in local-currency debt as well as the longer-standing dollar-denominated debt. There also are a significant number of convertibles and dividend-paying stocks, and funds that invest in those securities, too.

There is nearly as much variety in emerging-markets funds as you find among offerings that focus on the developed world, and that can help you round out your portfolio without driving up risk too far. You can choose a more aggressive fund but make it a small part of your portfolio, or you can have a bigger weighting in a lower-risk fund. You can even have some of both in order to further diversify your holdings.

The long-term benefits of emerging markets don't mean you'll have smooth sailing along the way. When U.S. and European markets have sold off in recent years, emerging markets have often gone down as much or more as traders play the risk-off/risk-on game. I don't expect this to make you feel better in the week that we have a market meltdown, but you may well feel better 10 or 15 years down the road as many emerging markets have the potential for stronger growth and greater stability.

With that in mind, I've pulled the emerging-markets funds with Morningstar Analyst Ratings of Silver and Gold and ranked them by their biggest loss over any time period. (Always a surefire way to throw cold water on an enthusiastic investor.) We call it the maximum drawdown--which essentially tells you what the worst loss was that you could have suffered if you'd bought at the top and sold at the bottom. Obviously, bigger losses than those are possible, but it gives you some idea of the downside.

Lower Risk
 PIMCO Emerging Markets Local Bond  had a worst loss of 25%. The appeal of this Gold-rated fund is clear. You diversify away from the dollar and euro and do so in a tamer format because you own debt rather than equities. By bond-fund standards it's high risk, but it's clearly high reward, too. One note about that loss, though, is that the fund has been around five and a half years. Had it been around for the late 1990s' emerging-markets currency meltdown, it would likely have lost quite a bit.

 Matthews Asian Growth & Income  suffered a max drawdown of 38.1%, which is actually much better than most emerging-markets funds. The fund is about 80% stock; the rest is in convertible bonds, corporate bonds, government bonds, and preferred stocks. Even the equities it buys tend to be a tad less risky as management favors dividend-payers.

In a similar vein is Gold-rated  Matthews Asia Dividend , which suffered a max drawdown of 35%. Many emerging-markets stocks pay a dividend and, just as in the United States, dividend-paying stocks in Asia tend to be less volatile than the rest of the market.

Silver-rated  Fidelity New Markets Income  invests mostly in dollar-denominated bonds, but it has still done a good job on risk. Manager John Carlson's max drawdown was 39.6% because he follows a cautious strategy of investing in the safest bets and trimming areas vulnerable to short-term problems. Again, while that sounds bad, other emerging-markets bond funds have been much worse.

Higher Risk
 Vanguard Emerging Markets Stock Index is Silver-rated for its low cost and quite-broad exposure to emerging-markets stocks. However, like all index funds, it is fully invested and that exposes it to short-term pain--hence, this fund's max drawdown of 62.65%. The fund's diversification helps trim losses a bit, but, when emerging-markets equities sell off, it's often en masse. This fund pays the price. Even so, the fund has produced strong returns over the long haul.

Silver-rated  Matthews India shed 69.1% at worst. Matthews does a good job of stock-picking and even avoids some of the higher-risk stocks. Yet there's only so far you can go with a single-country emerging-markets fund. Clearly, this is a fund you limit to 5% or less of your portfolio.

 Matthews Pacific Tiger  is an excellent play on Asia given Matthews' depth and experience there. But take note of its 69.2% max drawdown. Again, long-term returns here have been fantastic, but if you plan on investing in this one for less than 10 years, you're in the wrong fund.

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Russel Kinnel has a position in the following securities mentioned above: MAPIX Find out about Morningstar's editorial policies.
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