They have taken their time. But the emerging markets have finally re-emerged, reclaiming their status as true growth investments.

As an investor, it’s hard not to conjure up political and economic upheaval, not to mention devaluations and defaults, when contemplating emerging markets. While emerging markets scream risk, let’s put aside the images of rioting in the streets of Buenos Aires for a moment and look at some numbers. For the last five years, arguably one of the worst half decades in terms of financial turmoil in recent memory:

• Emerging stock funds as a class generated compound annual returns of 9.1% with a total risk index of 1.39. That compares with a risk index of 1.00 for the average mutual fund.

• Technology funds averaged -0.3% over the same period with a total risk index of 2.73, for perspective.

• Emerging markets bond funds returned 18.0% annually, on average, for the same period and had an average total risk index of 0.70.

• In comparison, long-term U.S. government bonds were up 6.5% annually with a total risk index average of 0.67.

While these returns are impressive, emerging market funds have one other noteworthy investment attribute: emerging market stock funds are not highly correlated with domestic stock markets, and emerging market bond funds are not highly correlated with domestic bond markets—an important consideration in reducing overall portfolio risk through effective diversification.

Enticing But Risky Exotics

Emerging markets funds, while possessing some attractive investment attributes, are still relatively exotic and somewhat esoteric investment vehicles, an appropriate investment possibility only for investors with longer investment horizons—over five years—and those willing to take a little time to understand emerging market composition and risks.

What is an emerging market?

It is a country that, while not now an advanced industrial nation, is on the road and has public share ownership of corporations and trading in a sufficient number to attract investment interest. There are many more emerging countries than emerging markets. (See the accompanying box for a list of countries that are currently classified as emerging markets.)

Needless to say, if a fund has attracted your interest as an emerging markets investment, it is worthwhile to check the fund’s annual report (or go on-line to the site Morningstar.com) to determine whether the country allocations add up to an emerging market emphasis. An international stock fund specializing in China with 75% of its investments in Hong Kong, for example, is not an emerging markets fund.

The second point to understand about emerging market funds is that they have unique risks. These funds carry the usual risks of domestic stock and bond funds, plus another layer. Call it sovereign risk: devaluation of the currency, foreign exchange controls, default on debt, tax policies, tariffs, trade quotas, abrogation of contracts, confiscation, nationalization of industries, and commercial law policies.

While some of these risks are present in developed markets, the severity and frequency of occurrence is more pronounced in emerging markets. Perhaps that is as good a definition of an emerging market as any. Taking the emerging markets in their entirety, most of these risks are possible, many are probable and some have been a recent reality.

Given this long list of additional risks, country diversification when investing in emerging markets is not only prudent, it is critical.

Fund Characteristics

The emerging markets stock and bond funds as reported on by AAII’s Quarterly Low-Load Mutual Fund Update are detailed in Table 1.

Country Composition

There are some important differences in the composition of these emerging markets funds. Of the stock emerging funds, four are regional funds: three Latin America and one Asia. One fund, Matthews Korea, is a country fund. Country and regional funds are of higher risk than diversified emerging markets funds.

Fidelity Latin America, for example, has 49% of its investments in Brazil and 44% by value in Mexico. T. Rowe Price New Asia has 25% in South Korea, 17% in Taiwan and 15% in Hong Kong.

While Hong Kong is considered a developed economy, the small percentage invested in Hong Kong does not divert this fund’s mission of emerging markets.One fund that didn’t make the list, however, is the Fidelity China Region fund. It’s ticker, FHKCX, is a clue why. This fund has 50% invested in Hong Kong firms and only about 8% in China, less than the 12% it has in the United Kingdom (the balance is invested in Taiwan, 17%, the U.S., 6%, and South Korea, 3%). Of course, the argument could be made that investing in firms that do business with China is a safer entry to the Chinese market. But direct plays are what emerging markets funds should be about.

Diversification

In terms of diversification, the Vanguard Emerging Markets Stock Index is worth a look. Its major regional exposures are 60% in Asia (excluding Japan) and about 20% in Latin America. As for country exposure, South Korea (21%), Taiwan (14%) and Mexico (8%) round out the top three. This fund is designed to track an emerging markets index reported by Morgan Stanley Capital International (MSCI).

The three emerging market bond funds are all heavily invested in Russian, Brazilian and Mexican bonds but all hold a wide range of other issuers from Bulgaria to the Philippines. Most bonds are issued by governments or government agencies. While diversified across many countries, a default on the magnitude of Argentina’s for one of their major country holdings, though unlikely, is possible.

Yields

The yields on these emerging market bond funds are not that high—the majority of their total returns are from capital gains. International funds usually carry higher expense ratios than domestic funds and expenses are netted out against income, reducing yields. Scudder Emerging Markets Income fund, for example, produced a 5.7% yield, not particularly high given the stated interest rates on the bonds they hold, but not surprising when Scudder’s high expense ratio, 1.66% annually, is factored in. In short, these emerging market bond funds are total return funds, not high-income funds.

Are Emerging Funds for You?

Emerging market funds are not an investment for all investors. But if you currently devote a portion of your portfolio to international funds, then emerging market funds may make sense, as long as you have a long investment horizon and understand their investment profile, taking the time to ensure that you are diversified within the emerging markets arena. How much of your portfolio should be devoted to emerging markets? If, for example, your portfolio now holds 20% in international investments, no more than half in the emerging markets sector, 10%, would probably be reasonable. A commitment beyond 10% of your portfolio to emerging markets would be hard to justify for even investors with the highest of risk tolerances. Emerging markets funds individually have explosive return potential and equally explosive risks, but the addition of these funds to a portfolio, given their low correlation with domestic stock funds over time, may just lower overall portfolio risk while boosting portfolio returns.

EMERGING MARKETS: A COUNTRY GUIDE
What countries are classified as emerging? The table below shows what is generally recognized as the emerging market universe, as classified by the Morgan Stanley Capital International Emerging Market Index. Some of the entries—as well as some of those excluded—may surprise you. World powers, such as Russia and China, make the emerging markets list. However, New Zealand, for example, is classified as a developed market. And Hong Kong itself (now part of China) is classified as a developed market, while Taiwan is listed as an emerging market.
Country	Major Exchange*	Stock Market Index
Asia
China	Shanghai Stock Exchange	SSE Composite Index
India	National Stock Exchange of India Ltd	S&P; CNX Nifty Fifty
Indonesia	Jakarta Stock Exchange	JSX Composite
Malaysia	Kuala Lumpur Stock Exchange	KLSE Composite
Pakistan	Karachi Stock Exchange	KSE All-Share Index
Philippines	Philippine Stock Exchange	PSE Composite
South Korea	Korea Stock Exchange	KOSPI
Taiwan	Taiwan Stock Exchange	TAIEX
Thailand	Stock Exchange of Thailand	SET Index
Europe, Middle East and Africa
Czech Republic	Ljubljanska Borza	Slovenian Stock Exch Index (SBI 20)
Egypt	Cairo and Alexandria Stock Exchanges	CASE 30 IndexHungary
Israel	Tel-Aviv Stock Exchange	All Shares Index
Jordan	Amman Stock Exchange	ASE Index
Morocco	Bourse de CasaBlanca	MASI (Moroccan All Shares Index)
Poland	Warsaw Stock Exchange	WIG
Russia	RTS Stock Exchange	RTS Index
South Africa	JSE Securities Exchange	FTSE/JSE All-Share Index
Turkey	Istanbul Stock Exchange	ISE National 100
Latin America
Argentina	Merval (Mercado de Valores de Bueno Aires)	Merval Index
Brazil	Bovespa (Bolsa de Valores de Sao Paulo)	Ibovespa (Bovespa Index)
Chile	Bolsa de Comercio de Santiago	General Stock Price Index (IGPA)
Columbia	Bolsa de Valores de Colombia	na
Mexico	Bolsa Mexicana de Valores	Price & Quotations Index (IPC)
Peru	Bolsa de Valores de Lima	General Index (IGBVL)
Venezuela	Bolsa de Valores de Caracas	General Index
* Some countries have several stock exchanges. In general, the largest exchange is listed here.