Unfortunately, a vast number of emerging market stock and bond funds hedge against currency risk, according to Morningstar. That may be a mistake. By hedging the currency risk in emerging markets, managers inhibit the excess return over the risk-free rate on a portfolio with a mix of asset classes, according to a 2013 study by Rutgers University economics professor Uzi Yaari.

Despite the instability, emerging market fund managers stress that the risk is worth it. “Emerging market equities have very favorable valuations and better growth metrics versus developed markets,” says Ruff of Forward. “With prospects for more favorable politics in much of the [emerging market] world, including Indonesia, Asia, Brazil and Turkey, we believe these markets can show much stronger relative performance going forward.” But he adds that emerging market labor productivity may decline as wages rapidly rise (the wage growth in the developed world is slower).

Investing in emerging market bonds isn’t a cakewalk either. Emerging market countries borrowed record amounts of money in the first half of 2014. Typically, investment-grade bonds are rated just “BBB,” the lowest level of investment grade, by Standard & Poor’s. Central banks have warned that record debt issuance could lead to trouble in a few years.  
 
That said, fund managers are cherry-picking investment-grade-rated companies with solid cash flows, high debt coverage and low debt-to-equity ratios. “Opportunities have arisen as a consequence of geopolitical tension in Eastern Europe and the Middle East,” says Mike Conelius, manager of the T. Rowe Price Emerging Markets Bond Fund. “We are finding attractive yields in corporate credits with strong capacity to service their external obligations.”

He says valuations remain relatively attractive, particularly for investment-grade-rated issues. On the plus side, the Ukraine government is taking positive steps with help from the West, especially the International Monetary Fund. He has reduced his Russia exposure, but is taking small positions in domestic-oriented companies where the threat of new sanctions is diminished. Conelius says India’s recent election could be a “game changer” for reigniting growth potential. “India could be the next Mexico in terms of policies and growth,” he says. “We could see a whole second wave of companies coming out of India. Mexico is still a tremendous opportunity on the energy reform front.”

Conelius stresses, however, that there is political turmoil in Turkey, Indonesia, Brazil, the Middle East and Ukraine. Another risk is the likely rise in U.S. interest rates and volatility in currency values.

His fund is about 60% invested in dollar-denominated foreign government bonds and the rest in corporate bonds. The fund sports a duration of six years. And 58% of the portfolio is invested in Brazil, Mexico, Venezuela, Turkey, Indonesia and Russia.

Michael Gomez, manager of the PIMCO Emerging Markets Bond Fund, also keeps the duration of the fund’s holdings at just six years because of the market volatility. He is overweighted in Mexico, Luxembourg, Indonesia, Venezuela and Ireland. About 35% of the holdings are in corporate bonds. The largest holdings include bonds from Russia, Mexico and the Philippines.

Meanwhile, currency diversification is the focus of the Lazard Emerging Income Fund. Manager Ardra Belitz invests in short duration corporate and sovereign bonds in local currencies in countries such as Africa, Latin American, Asia, Eastern Europe and the Middle East. The correlations among local debt markets and developed countries are low, she says.  
   
“The portfolio has the potential to benefit in a period of rising interest rates as global demand conditions improve,” Belitz says. The reason: the sizable depreciation in local currency valuations in recent years.

 

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