Investors Should Keep Emerging Markets

Investors who poured money into emerging markets mutual funds the last two years may be feeling a little uneasy after the funds' sharp decline over the past month. Fund analysts aren't so worried -- they say the downturn is only a correction in markets that are fundamentally strong.

And, they say, while these investments are risky, emerging markets deserve a place in a long-term diversified portfolio.

After delivering a three-year return of more than 40 percent, emerging markets funds had a negative return of 8.41 percent in the past month, pulling its year-to-date return down to a still-hefty 10.23 percent, according to fund tracker Morningstar Inc.

"The recent sell-off is not a sign of long-term trouble," said Arijit Dutta, a mutual fund analyst at the research firm Morningstar. "People were chasing performance, so with so much cash going in, it is bound to cause the markets to overheat."

Emerging market funds had cash inflows in the United States of $23 billion in the first quarter of 2006, equaling the total for all of 2005 and more than five times the level in 2004, according to Brad Durham, managing director at Emerging Portfolio Fund Research.

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"They got ahead of themselves because of excessive liquidity," Durham said. "The market was due for a correction."

That came as a huge outflow -- some $5 billion -- in the week ended May 24, Durham said.

Analysts say emerging markets funds are essential for long-term investors seeking growth. Julian Thompson, portfolio manager for RiverSource Emerging Markets Fund, recommends holding funds at between 5 percent and 20 percent of a portfolio.

Morningstar's Dutta is less bullish. "We have been saying for more than a year to cut holdings in emerging markets to about 5 percent to 8 percent," he said. "If your portfolio has gotten out of balance because of the huge gains, then now would be a good time to take some chips off the table and put them somewhere else."

Dutta advises caution because the funds are by nature risky, targeting companies based in so-called developing economies where volatility is high and the risk of an economic collapse is real. Remember the crises of the 1990s that swept from Mexico to Asia then to Russia and Brazil.

"Emerging markets do have a role to play, but it should be limited because of the volatility," Dutta said.

The funds typically hold stocks in 70 to 100 companies based primarily in those once-troubled areas, but also in India and especially China. They include smaller countries in Latin America, Eastern Europe and Africa, too.

The gains notched in the past three years came as companies in those regions benefited from soaring prices for commodities such as oil and gold or soy beans and coffee.

There has been talk that the recent downturn -- led by a sell-off in India that sent the country's stock market tumbling -- is the start of a new period of volatility. The reversal started over concerns that China might slow its economic growth to prevent its economy from overheating, said RiverSource's Thompson.

"That was overblown," he said. "China's performance has been profound and it will continue to support commodity prices."

Durham said the drawdown was cyclical. "It's happened in the last three years at the start of the second quarter, usually because of some U.S. economic data," he said. "Global liquidity dries up and people take profits."

Thompson, meanwhile, said the three-year run was not an aberration, but became possible because of more stable markets.

"Economic reforms in the 1990s strengthened central banks, which now keep a closer eye on inflation," he said. "That, combined with high commodity prices, kept local currencies strong and inflation low."

"These countries are in better shape in terms of trade balance, foreign exchange reserves and stronger central banks," Dutta said, adding that "more wealth is driven internally so there is more spending power and a growing middle class."

As a result, emerging markets, while still largely dependent on foreign demand, particularly for commodities, have become less vulnerable to slowdowns in demand from abroad. "These are not our fathers' emerging markets," Durham said.

Again, that's not to say there is no risk in this investment category. "The markets are more stable, but they are still volatile compared to the developed economies," Dutta said. "(Interest) rate increases could cause a problem, but the source of trouble tends to be something no one expects."

Emerging markets are not a tool for the short-term investor. They should primarily serve as the riskier portion of a weighted portfolio, Dutta said. "For the longer term, think about balance, not about timing."

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