Passive vs. active investing is another
issue in the red-hot emerging markets sector.

    It's 2006. Do you know where your correlations with international stocks are? Right about where they were ten years ago, actually, despite all the globalization hype. That means from a diversification standpoint, the story in foreign equity investing remains emerging markets, a term coined in the early '80s to denote middle- and low-income countries and nowadays often represented by the MSCI EM Index. A subsector dubbed the "frontier" economies (nations with the tiniest market caps, such as Croatia, Estonia and Botswana, measured by the S&P/IFCG Frontier Composite Index) has scant correlation to U.S. equities (see Figure 1).
    Yet concerns about the asset class's recent fortunes have some investors muttering "bubble." Last year, the Mexican stock market jumped nearly 50%; Egypt's, about 150%. Among the countries whose indexes reached new highs was Dubai, which crested in August-then promptly shed half its value over the next seven months. With such gut-wrenching performances, advisors have to educate clients at both ends of the risk-tolerance spectrum about the asset class.
    "Sometimes an aggressive client will almost like it too much and want to bet the farm on, say, China," observes David Cowles, director of investments at Mosaic Financial Partners in San Francisco. Conversely, conservative investors need reassurance. "For clients who are concerned that emerging markets are too risky, we have to demonstrate the diversification benefits of including these stocks in their portfolio," says Cowles. His standard equity allocation to emerging markets is 9%.
    But you'd better explain the risks, too, he adds, because there are some unique ones. Emerging markets are not like developed nations. Historically, budding economies have been more sensitive to interest rate movements and more prone to bouts of inflation frequently triggered by sudden shifts in capital flows. Today, the political systems remain corrupt and unstable, the rule of law weak.
    The capital markets in many developing countries are thin and immature, too, so trading is expensive, although costs are coming down as exchange volume increases. Still, U.S. fund managers pay about 40 basis points to trade in Thailand, one way, and likewise in Turkey. Even in Hong Kong the commission is around 20. Illiquidity costs extra. It creates wide bid-asked spreads, in many cases. Plus, a fund's trade can move the market price as the broker fills the order.
    That said, emerging markets as a group appears less risky than when the asset class soured a decade ago. In fact, "the fundamentals have never been stronger," says Nathan Sandler, manager of TCW Emerging Markets Income Fund. "Economic stabilization and structural reforms have been the catalysts for a transformation process leading, ultimately, to higher relative growth rates, declining inflation, an expanding role for the private sector and gradually improving living standards," Sandler says.
    The recent run-up in commodity prices is a big part of the story, adds Jeff Grills, co-head of the emerging markets debt team at JPMorgan Asset Management. For example, the bonanza allowed raw materials exporters Brazil and Argentina to prepay their International Monetary Fund loans a few months ago.
    Wealth spawned by an improving economy further girds its soundness, as burgeoning domestic markets create national self-sufficiency. "In the past, most emerging economies were based on exporting to the U.S., so if the U.S. got a cold, they got pneumonia," says Joseph Devine, senior-vice president and portfolio manager at Nicholas-Applegate Capital Management in San Diego. "Now that emerging economies are more focussed on domestic consumers, they could continue performing well if the U.S. economy slows down."
    As emerging economies strengthen, many get re-rated. In 1997, about 10% of the JPMorgan Emerging Markets Bond Index Global, which tracks government debt issues, was investment grade. "It is now over 40%," says Gunter Heiland, Grills's co-head at JPMorgan Asset Management.

Risk: The Big One
    Still, one danger has not abated: country-specific risk. Volatility can be sky-high, only to be exacerbated by a crisis at any moment. Fortunately the risk is easy to mitigate because the various emerging markets are remarkably out of sync with one another, and have been for years. A 2002 Federal Reserve Bank of New York study found an average correlation of .19 between eight of the larger ones from 1976 to 1999.
    That's not much different from the last five years' .20 average intercorrelation between a slightly different set of countries calculated by Cliff Quisenberry. The portfolio manager at Parametric Portfolio Associates in Seattle and subadvisor of the Eaton Vance Tax-Managed Emerging Markets Fund says that the smallest emerging economies are even more uncorrelated-.10 for the last five years, on average. That helps explain why the S&P/IFCG Frontier Composite shows greater returns for that period, with lower risk, than the large-country-weighted MSCI EM (Figure 2).

Invest Actively Or Passively?
    There are good arguments for both investing styles, and against them. The knock against active (besides underperforming the MSCI index, on average) is high cost. In addition to the trading expenses funds can rack up internally, Morningstar says you'll pay the average active manager a tidy 195 bps.
    Unfortunately, passive strategies may not offer the requisite diversity. Just four countries-South Korea, South Africa, Brazil and Taiwan-account for 51% of the Barclay's iShare exchange-traded fund that tracks MSCI EM, and 59% of Vanguard's Emerging Markets VIPER ETF, which emulates a different barometer. The iShare also suffers from company concentration-Samsung Electronics is more than 6% of the portfolio, and four other holdings weigh more than 2.5% each.
    In theory at least, active management should pay off in this asset class. Emerging markets are less efficient than developed ones, no question. Therefore astute investors have greater opportunity to snare excess returns, or alpha, if we are to believe the efficient-markets hypothesis.
    Devine, a top-quartile manager whose Emerging Markets Opportunities Fund has handily outperformed the index, takes a bottom-up growth approach. He frequently favors companies doing business with locals. "The domestic consumption theme is the real story in emerging markets right now and will continue to be," he asserts. One of his current favorites is Brazil's Cyrela Realty, a high-end residential property developer. Falling interest rates in Brazil, rising consumption and pent-up demand for real estate could take this successful company even further, he says.
    Another pick is Hengan International-"kind of the Kleenex of China," Devine calls it. In addition to tapping China's domestic consumption tidal wave, Hengan has established itself as a quality brand, a leverageable marketing strategy. "When there is wealth affect, people begin to look more at quality than pricing," he says.
    Quisenberry is also optimistic. His strategy, which has beaten the MSCI EM over the last half-decade with less risk, involves overweighting stocks in small countries, relative to the index, and rebalancing aggressively. "The combination of these countries' low intercorrelations and high volatility means that if one is down a lot, you can usually find another that is up a lot. Rebalancing capitalizes on that," he says, adding that his fund currently holds companies in about 40 countries.
    Another benefit of rebalancing is the self-imposed contrarianism. It helps lower illiquidity costs. "We're selling when we're overweight because the market has done well and everybody else wants to buy, and we're buying when everybody is selling," Quisenberry says.
    Active funds, however, have a great unknown: currency exposure. Fund companies typically don't indicate whether they hedge it, says Andrew Clark, an analyst at Lipper, a Reuters company that analyzes mutual funds. "You can't usually determine how much of a fund's return is due to currency movements and how much is the result of stock picking," he says. "Most fund companies don't disclose that anywhere, to anybody."

But Is There A Bubble?
    No, says Devine. "Valuations on the whole are still pretty compelling. The MSCI EM's forward P/E ratio is lower than that of the European, U.S. and Japanese markets, although certain countries are overvalued, like India. We are seeing excessively high valuations there."
    Perhaps the strongest hint of bubble is that investors seem eager to assume greater risks in emerging markets while accepting smaller potential returns. Devine cites growing interest in small- and mid-cap companies as well as in the frontier markets. Moreover, some managers are staking private equity positions, he claims. "The risk appetite in emerging markets has grown stronger," Devine says. "But even if there is a bubble, it could be five years out with plenty of opportunities in the meantime."