Nearly a year ago, Thailand gave up trying to defend its currency and let market forces devalue the baht. It was like pulling a loose thread on a cheap suit. Thai stocks plunged, and so did stocks and currencies in Malaysia, the Philippines, South Korea, and Indonesia. Hong Kong equities melted in the fall, and this year, markets in Latin America--and now, Russia--are sinking as well.
The carnage has brought into question the whole concept of investing in equities to capitalize on the development of rapidly growing economies. Indeed, some pros have stopped wondering when these economies will turn up and instead are asking whether emerging market investing has any legitimacy at all. "From a risk-reward standpoint, it's hard to justify investing in emerging markets," says Robert Markman of Markman Capital Management, who moved heavily into emerging market funds in 1993, when they were delivering enormous returns. Now, says Markman, "there's a bull market in the U.S. and Europe. Why would you want to invest in markets where financial disclosure is poor, regulation is weak, and many corporate leaders act in ways that would, in the U.S., land them in jail?"
FINDING BOTTOM. Many investors ignored these factors when the markets were sizzling. But when pros express such vitriolic sentiments, it's often a sign that a battered market is near bottom. So would it be smart to open your checkbook and start buying? Trouble is, finding a bottom in these markets is tricky. Months ago, many analysts expected that emerging markets would have found their footing by now, but that obviously isn't the case. The dollar-denominated Morgan Stanley Capital International Emerging Markets Free Index lost 14% in May and fell 12% more through June 15, bringing its 1998 drop to 21.1%. The index is down 43% since July. Diversified emerging-markets mutual funds--the vehicles most individuals use to invest--have done little better than the widely watched index. They're down 17% this year and 32% for the 12 months ended June 15. "In 12 years of following emerging markets, investor sentiment is about the worst I've ever seen," says Morgan Stanley Dean Witter strategist Jay Pelosky.
As markets have cratered, trading volume has slowed to a trickle. Activity in Telefonos de Mexico, one of the bellwether emerging-market issues, is down to 20 to 25% of its volume of two years ago. Volume in the Russian stock market is down about 80% from 1997, when the market was soaring. After a year of battering, these markets seem to be falling not so much because of a crush of sellers as of a dearth of buyers, as cash flows to emerging-market funds have dried up.
Normally, when a market or sector gets trounced, investors go back to historical records to help them gauge the depths of the downswing by what happened in similar situations in the past. But there's not much history here. Most emerging-market indexes go back only about 10 years, and the bulk of emerging-market funds were launched in the early 1990s. In contrast, investors have nearly 30 years of reliable data on industrial countries' markets and more than 70 years' worth for the U.S.
That lack of history leads some analysts to ask whether emerging market equities do, indeed, form a separate class of asset with a risk-return pattern that's not correlated with any other class. Adding such an uncorrelated asset class can diversify a portfolio of, say, U.S. stocks, bonds, and real estate, and help shield it from shocks. To be sure, emerging markets have moved in the opposite direction from U.S. securities for more than a year. But even those who regard emerging markets as a unique breed counsel caution. Jeff Schwartz, a senior consultant at Ibbotson Associates in Chicago, still thinks that over decades, emerging markets should return about 10 percentage points more than developed bourses. But he says clients looking to buy at fire-sale prices should limit emerging markets to 20% of their foreign stock allocation. So if you plan to have 25% of your portfolio overseas, 5% might be in emerging markets. "I wouldn't make a major investment in these markets right now," says Michael Lipper of Lipper Analytical Services. "But if you're a long-term investor, you might start with a small one."
Before making any new investments, Lipper says, sell any emerging-market funds in taxable accounts that are in the red. Take the tax loss and make a new investment in a similar fund. You should probably consider a diversified emerging market fund (table) rather than bet on one country or region. The fund with the longest track record is Templeton Developing Markets I, run by Mark Mobius, the dean of emerging-markets investors (BW--May 11). While its five-year track record puts the fund at the top of its category, recent returns have been disappointing, largely because Mobius bought beaten-up Asian stocks too soon. You might also want to take a look at Templeton Emerging Markets Appreciation Fund, a closed-end fund on the New York Stock Exchange. It trades at a 20% discount to net asset value, making it cheaper to buy than the older closed-end fund, Templeton Emerging Markets, with a 3% premium, or the open-end Developing Markets Fund, with a 5.75% sales charge.
Fund watchers say there are good alternatives to Templeton. Among load funds, Morningstar analyst Bill Rocco says both Nicholas-Applegate Emerging Country A and Pioneer Emerging Markets A funds are noteworthy. Like Mobius, Pioneer's Mark Madden looks for battered value stocks, but he's quicker to trade them. In these tough markets, that seems to be a virtue--Pioneer was down only 8.7% in the 12 months ended in May, vs. Templeton Developing Markets' 28.2% drop. Nicholas-Applegate takes a different approach, preferring to buy pricier but still prospering growth stocks. So far this year, Nicholas-Applegate's growth style is producing better results.
Among no-load funds, some analysts like Montgomery Emerging Markets R for its relatively long history and the depth and experience of its management team. But recent years have been brutal for this fund. Another choice is an index fund--Vanguard International Equity Emerging Market, pegged to the Morgan Stanley index. The big advantage of this fund is an expense ratio of just 0.57%, a third of that for the average diversified emerging-markets fund.
Not everyone is a fan of the diversified approach. Investment advisers Alan and Steven Cohn of Sage Online prefer regional funds. They argue that these have a better combination of reward, risk, and expenses. Among their top choices are Scudder Latin America and Guinness Flight China. Another option is closed-end country and regional funds. Market turmoil has them selling at hefty discounts to NAV. Miami-based closed-end fund investor Thomas Herzfeld suggests the China Fund, at a 17% discount; Greater China Fund, at 16%; and Morgan Stanley Asia Pacific Fund, at a 22% discount. He sees them as trading opportunities and might well sell them if their discounts narrow sharply.
Perhaps the most conservative emerging market play is via a diversified international fund that has the ability to sit out the worst storms in developing economies--or bet on their recovery. Financial adviser Tim Medley in Jackson, Miss., is a fan of Acorn International Fund, which is investing selectively in Hong Kong, Singapore, and Latin America. All told, emerging market equities are 14% of the fund. Medley says if star manager Leah Zell "puts some of the fund into emerging markets, then I'll trust her judgment." Other international funds that invest in emerging markets include Artisan International and BT Investment International Equity.
Although timing any comeback in emerging markets is nearly impossible, some long-term bulls believe markets are so oversold that it won't take much to bring them around. "The news doesn't have to turn positive, only less negative," says Morgan Stanley's Pelosky. Markets are so illiquid, he argues, that "when the turn comes, it's going to be a very aggressive move up." If you have a stomach of cast iron and an eye for bargains, you might want to make a modest bet that the carnage is coming to a close.