What to consider before you buy an emerging-markets fund

Emerging markets are hot again, but if you're thinking of jumping in, first you should know what drives the market.

  • By Simone Constable,
  • The Wall Street Journal
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Investors are flocking back to emerging markets, after dumping billions of dollars of emerging-markets securities and funds late last year.

For those who are thinking of following suit by putting their money to work in emerging markets, here are some important considerations.

A look at emerging-market bond ETFs

Money has been flooding into bond ETFs but what will happen if the tide of money turns.

1. Why the turnaround? Investors are getting excited about emerging markets across the globe, placing bets on countries as diverse as India, the Czech Republic and Russia. Starting with December last year, each month an average of $24.4 billion has flowed into emerging-markets stocks and bonds, according to data from the Washington-based Institute for International Finance. The eight straight months of inflows follow a sustained run of cash out of those countries that started on Nov. 11, just after the U.S. election, and became the longest continuous run of daily outflows—not ending until Dec. 16—since the institute started tracking these flows in 2005. The outflows reversed course as concerns faded that the dollar would surge in the wake of the election because of rising interest rates in the U.S., and that trade wars would break out across the globe—both bad for emerging-markets economies and companies.

2. Expect volatility. The recent sharp changes in flows into and out of emerging-markets securities added to a history of volatility in those markets. Annualized volatility for the S&P Emerging Broad Market Index was 23.3% over the 10 years through July 31, compared with 15.2% for the S&P 500 (.SPX), according to an analysis from S&P Dow Jones Indices. The figures for the past five years showed a similar trend. The volatility measures are based on returns in U.S. dollars.

3. The dollar matters. The strength of the dollar makes a big difference to returns. "Emerging-market economies and stock markets will do especially well if the dollar weakens under Trump," says David Ranson, director of research at HCWE & Co. He explains that while a rising dollar attracts more capital into the U.S., a falling one repels it, sending some of that money into emerging markets. A weaker dollar also boosts returns on foreign securities for U.S. investors. Mr. Ranson notes that the value of the dollar hasn't changed dramatically since President Trump took office. Still, it is worth watching.

4. Business confidence is key. The dollar is just one part of the equation. Business confidence is also important. Despite the rush out of emerging-markets securities after the U.S. election, they have done well over the past year, Mr. Ranson notes. The S&P Emerging Broad Market Index was up almost 20% in the 12 months through July 31. That reflects reduced business anxiety around the world, Mr. Ranson says. He uses yield spreads in the U.S., or the difference between what businesses pay to borrow money and the lower rates the Treasury pays, as a benchmark for such anxiety. Those spreads have shrunk about 30% on average over the past 12 months, according to Federal Reserve data.

5. Little correlation. A portfolio allocation to emerging-markets stocks likely won't perform in the same way as U.S. stocks. "In 2013 emerging-markets stocks were down while U.S. stocks were up," says Charlie Bilello, director of research at investment-advisory firm Pension Partners in New York. "You need to understand that wasn't the first time and it won't be the last time that such a thing happened." The lack of correlation can be frustrating when emerging markets are down, but should help reduce the overall volatility of a portfolio that holds assets from various regions.

6. The Fed isn't everything. Myths about emerging markets abound. One relates to U.S. interest-rate policy. The Fed's policies don't necessarily dictate how emerging markets will perform. "It's just not as simple as if the Fed hikes rates then emerging markets go down" because more money will be drawn to U.S. securities, says Mr. Bilello.

7. Neither are commodities. Another myth is that all emerging-markets economies, and so company earnings, are related to the strength of oil prices or other commodities. A case in point is India, which imports oil and therefore tends to benefit from lower energy prices. Of course, Russia is an example of an emerging market that does depend in large part on oil exports. "Most of the other countries are not driven by energy," says Mr. Bilello.

8. Value matters. Be wary of investing just because economic growth is faster in an emerging market than in the leading industrial countries. "Growth shouldn't be the primary reason," says Tim Courtney, chief investment officer of Exencial Wealth Advisors in Oklahoma City. That's because the expectation of relatively high economic growth rates already is factored into the prices of many emerging-markets securities.

The trick is to look at the valuations of the stocks in those countries, Mr. Courtney says. In general, stocks in emerging markets right now are trading at big discounts when compared with the shares of similar U.S. companies, he says. "When you have a wide discrepancy in valuations, those assets that are priced more cheaply tend to outperform," Mr. Courtney notes.

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