The many ways into emerging markets

While some travellers are wary of visiting emerging-market countries, they feel very differently about investing money there. Some $19.5 billion cascaded into emerging-market equity mutual funds in the first nine months of 2011, following a $46 billion flood from U.S. investors in 2010, according to the Boston Consulting Group. In both periods, emerging-market fund inflows exceeded those of any other fund category save for core bond funds.

Everyone, it seems, knows that emerging markets are where the growth is these days. The International Monetary Fund expects such economies to grow at four times the rate of "advanced economies" this year. Far less obvious, though, is the best way to profit from their growth. Some of the trendiest investing options have serious drawbacks.

One of the most popular routes into less developed markets is the MSCI Emerging Markets Index. It tracks 822 emerging-market stocks and is the basis for many mutual funds and exchange-traded funds, including the $45 billion Vanguard MSCI Emerging Markets ETF (VWO). As with many market capitalization-weighted indexes, the larger a company gets in the index, the more it dominates returns.

That becomes a problem when many of the fortunes of the big companies are tied more to global trends than to local growth, says Matthew Rubin, director of investment strategy at Neuberger Berman. The top stock in the MSCI Index is South Korea's Samsung Electronics, which got 42 percent of revenues in Europe and the Americas last year. It's not that export-led growth is bad, it's only that you're not getting the diversification away from developed markets that you think you are.

Investors wanting access to trends such as the growth of a middle class in countries like China, India and Brazil must invest in smaller companies with a local focus, says Rajat Jain, a partner and senior research analyst at Litman Gregory Asset Management. In October, Jain's firm announced plans to gradually boost its clients' emerging-market exposure from five per cent to 20 percent. In a report, the firm noted that in its "subpar recovery" base case scenario, emerging-market equities should still generate low double-digit returns.

One way to get a more direct connection to a local market is via a fund such as the Van Eck Market Vectors Brazil Small-Cap ETF (BRF). The 2.5-year-old fund's small-cap focus — it's made up of 74 Brazilian companies with an average market capitalization of $1.8 billion—prevents it from being dominated by huge companies such as Petroleo Brasileiro SA, the $171-billion oil company known as Petrobras. In the past two years, Van Eck also launched an India Small-Cap Index ETF and a Latin America Small-Cap Index ETF.

Greg Peterson, director of research at Ballentine Partners, prefers Dimensional Fund Advisors' Emerging Markets Small Cap Portfolio (DEMSX). He likes how the fund's holdings must qualify as value stocks based on criteria like price-earnings ratio, and says the fund's expense ratio is "relatively low" at 0.78 per cent.

Small-cap emerging-market stocks, of course, can be more volatile than their big-cap brethren. And those brethren have been pretty volatile lately. From August 1 to October 4, the MSCI Emerging Markets index plunged 28 percent.

Smart managers of actively managed funds can purposefully buy stocks with lower volatility, notes Morningstar senior fund analyst Karin Anderson. And, some of those managers have the freedom to buy developed-market stocks with high emerging-market exposure, another way to potentially damp volatility. Anderson cites American Funds' New World Fund (NEWFX), which, along with many emerging-market stocks, includes among its holdings Swiss food company Nestlé and Danish drug maker Novo Nordisk.

That's a strategy also employed by David Herro, chief investment officer for international equities at Harris Associates. For him, it's a way to buy exposure to emerging-market stocks at a time when he thinks prices are expensive.

Rather than own expensive shares of a Chinese brewing company, Herro invests in Heineken, a Netherlands-based brewer. Heineken gets two-thirds of its profits from outside Western Europe, including 23 percent from Africa and the Middle East. Investors have "overpriced" emerging-market stocks while they have "underpriced companies located elsewhere that do business in emerging markets," Herro says.

Actively managed international funds can be costly. One of the best-managed funds, says Morningstar's Anderson, is the Oppenheimer Developing Markets Fund (ODMAX). That said, its 1.35 per cent expense ratio is about as high as investors should ever go, she says, and is about four times the 0.35 percent fees on the Vanguard Emerging Markets Stock Index Fund.

To try and meet investor demand, investment companies are getting creative. Firms are coming up with many more new products that try to capture emerging-market growth with increasing sophistication, says Brent Beardsley, a partner at the Boston Consulting Group. One, the ASG Growth Markets Fund (AGMAX), was introduced October 24. It holds emerging-market stocks while using derivative contracts to reduce the fund's volatility. About a quarter of its portfolio is in derivatives tied to global stocks, bonds, commodities and currencies. It is co-managed by Andrew W. Lo, a Massachusetts Institute of Technology professor.

Such products are coming out because "there are more people chasing opportunities than there are opportunities to invest in," says Beardsley. The number of good companies listed on stock exchanges isn't rising as fast as investors' enthusiasm, he notes.

That means emerging markets remain a place where investors need to be cautious-no matter how fast their economies are growing.