The Surge to Emerge

Emerging market stocks have performed poorly this year, but it's not time to write off this asset class just yet. Emerging market stocks still deserve an allocation in all but the most conservative, riskadverse investment portfolios.

How bad is it?
In 2004 through the end of August, the Vanguard Emerging Markets Stock Index Fund gained just 0.6%. Compare these results with 2003 when the fund surged 55%.

The Emerging Markets Stock Index Fund is designed to match the performance of the Select Emerging Markets Free Index of approximately 500 common stocks of companies located in emerging countries around the world. The 500 Index Fund mimics the S&P 500 Index, which is dominated by the stocks of large U.S. companies. These funds closely track their respective target indexes.

Emerging markets include the vast majority of the world's economies, countries such as Mexico, China, South Africa, and Singapore. Although many in number, the combined economic power of emerging markets pales in comparison to the world's top economic powerhouses: the United States, Japan, and several countries of Western Europe.

Strong Growth Projected
But this is changing. Emerging economies are growing rapidly and are projected to outpace growth in developed markets. For example, the average real gross domestic product (GDP) of Brazil, Russia, India, and China (the BRICs) is projected to increase 6.8% this year, then rise another 6% in 2005. Compare this growth to the more sedate projected average of developed economies: 3.6% this year and just 2.6% in 2005. Real GDP, by the way, excludes the effects of inflation. Last year Goldman Sachs predicted that in 40 years, the total output of the BRICs will be more than that of a group of six of the largest developed economies. An investor might expect to find the stock of companies in these fast-growing economies rather expensive. Not so.

To understand why, let's compare the P/E ratios of emerging market stocks with those of more developed markets. The P/E, or price/earnings ratio, is a common measure used to gauge how expensive a stock is. The higher this ratio, the more expensive the stock. Sometimes there's a good reason for a higher cost. Fast-growing companies, for example, generally have higher P/Es than slow growers.

In contrast, fast-growing emerging market stocks have lower P/Es on average than relatively sluggish large U.S. companies. At the end of June the average emerging-market company P/E was 13.6, compared with 21.7 for the S&P 500.

Fast growth and comparatively low prices, then, characterize today's emerging stock markets. Yet many investors are hesitant to invest overseas. Emerging market companies in particular have historically proved far riskier than domestic stocks. The economic, political, and legal development of emerging markets is judged less mature. Because of this, these investment markets are subjected to higher levels of default, corruption, political unrest, and property confiscation, just to name a few. Overshadowing all of this is currency risk, the possibility that the value of emerging currencies will have dropped when converted into U.S. dollars.

A History of Problems
As this is being written, the Russian government is apparently taking over one of the country's major oil companies, Yukos, and investors have suffered significant loss. Argentina is still recovering from a 2001 debt default and subsequent currency devaluation that sent investors scurrying for the exits. There was a Mexican crisis in 1994-95, an Asian meltdown in 1997, and a Russian default in 1998. In each case, emerging markets plunged. In short, investing in emerging markets remains risky.

Let's not be too smug, however. The 1990s tech bubble and subsequent meltdown reminded us about stock market risk here in our own country. Today, we continue to have problems in the U.S. with accounting irregularities, bankruptcies, investor fraud, corruption, etc. Investing, whether at home or abroad, is inherently risky business.

Risks Should Continue to Decrease
Over time, emerging market risks should continue to decrease as these countries draw closer to the economic, political, and legal standards found in more developed economies. For example, the International Monetary Fund predicts continuing improvement in emerging country balance sheets. The credit rating agencies are starting to take notice. "Over the past five years there has been a steady increase in the credit quality of emerging markets issuers," reported bond management company Pimco in April, "with nearly 50 percent of the emerging market sovereign universe now rated investment-grade."

While the developed and developing economies of the world grow more interdependent and often prosper or suffer together, the pace of development among individual countries varies considerably. Moreover, emerging economies are increasingly trading and cooperating with each other. As this continues, emerging economies should become less dependent on and perhaps less affected by the fortunes of the developed economies. Thus emerging markets as an asset class should continue to diversify a portfolio and reduce overall risk.

Best Entry Point
Finally, not all emerging markets are created equal. It's a big job to evaluate these numerous economies and their companies. It's a job better left to a professional whose main responsibility is to monitor these temperamental markets. For most investors, then, the best entry point is through a low-cost noload mutual fund or exchange traded fund that invests in worldwide emerging markets.

Make sure, however, that your emerging market investment fits into an overall diversified portfolio allocation, and that you don't overdo it. An allocation of 5% or so of an overall portfolio is about right for most investors.