Emerging markets mutual funds are one of the fund industry's worst performers year to date. At the same time, Citibank attributes this year's 42 percent increase in profits to its exposure and strength in emerging markets like Latin America and Asia. Go figure.
We could try to make some sense of this, but it's all too often dangerous when investors try to think. A better alternative would be to just approach the opportunity mechanically like the managers of huge endowments and pension funds. For those of us who emulate those highly paid managers and who consider ourselves to be "re-balancers," as opposed to "market timers," this would be a time to consider taking a few chips off the table of some of our more stunning year-to-date and past-12-month winners and add them to an emerging markets fund.
A few funds to consider as examples for this exercise would be T. Rowe Price Emerging Markets and American Funds New World. The rationale behind investing beyond the United States and "Old Europe" is that emerging economies are growing faster than ours. This is what has attracted Citibank to these markets and their revenues from overseas are now greater than those they generate in this country, according to The New York Times.
Over the long term, investments that involve more risk generate higher average annual rates of return. This explains, for example, why small cap funds tend to earn 12 percent average annual returns versus the overall stock market's 10 percent over long periods.
Clearly, emerging markets would fall into a higher risk category, which explains why average annual returns over the past 10 years have been in the 13 to 14 percent range. It's the invisible hand of economic forces that rewards people who can stomach volatility. If this invisible hand didn't exist in nature, nobody would be motivated to take additional risk.
Apart from emerging markets in general, there is China, which is in a class by itself. Matthews China Fund invests exclusively in China and has taken a bath so far this year, with losses of more than 9 percent year to date. Even at that, however, its average annual return for the past 15 years has been almost 15 percent per year. It has lost money for the past three years. Anyone considering a more focused exposure to emerging markets should consider a fund specifically aimed at China.
The best book to read for background on China as an investment opportunity would be Burton Malkiel's "From Wall Street to the Great Wall." This is a clearheaded treatise of Chinese industry that includes a broad sweep of history and a "hype-free, in-depth investigation of the Chinese stock market ..." as the book jacket explains it. If the author's name sounds familiar, it's because he wrote another investment classic that every investor should read -- "A Random Walk Down Wall Street." This jaundiced view of the financial services industry constitutes some of the best advice regarding how to invest money that has ever been available in print.
Emerging markets can offer more than just opportunities in their stock markets. Emerging markets bonds, as Citibank has found out, can also offer opportunities to make money. The income return from bond interest over recent years has been in the 6.5 to 7.5 percent range for funds like T. Rowe Price Emerging Markets Bond Fund. The volatility can be difficult to stomach, because, for example, this fund lost 25 percent of its capital value in 2008, but that value snapped back and recovered totally within two years.
Meanwhile, the interest income continued unabated. In other words, while the capital value of the bonds dropped because of a misperception that they would default, they continued to pay the interest as required.
The bottom line is that emerging markets are worth some study for those who want to deploy a part of their portfolio to a higher risk area that, over time, would be expected to "move the needle" positively on either the stock or the bond side of the mix.