The Allure of Over There

By Barbara Kiviat

Emerging markets have been all the rage the past few years, with U.S. investors plowing billions of dollars into the far corners of the globe, from Pakistan to Peru. If you take a look at how some of those regions have performed, it's no wonder. The iShares MSCI Emerging Markets Index exchange-traded fund (ETF), which tracks a basket of stocks from such countries as Taiwan, South Africa, Turkey and Poland, is up 89% over the past two years. That trounces the S&P 500's 18% gain. A dip in stocks worldwide this spring shook emerging markets the hardest--India dropped 29%, Egypt 37%--but even that falloff didn't dampen the enthusiasm more than temporarily. According to AMG Data Services, money moved into emerging-market mutual funds and ETFs at the rate of $3 billion to $5 billion a month in the quarter leading up to the correction. Those funds lost money in the May and June swoon, but by the beginning of August, they were again taking in hundreds of millions of dollars a week.

It's hard to paint places as diverse as India, Mexico and Thailand with one brushstroke, but the story on emerging markets generally goes something like this. As economies in certain countries (China, India) take off, others that are rich in natural resources (Brazil, Chile) get pulled along when commodity prices shoot through the roof. Meanwhile, as many countries undergo structural changes, like floating their currencies (South Korea, Indonesia), the idea of investing in places that come with some pretty scary memories (the 1980s Latin American debt defaults, the 1997 East Asian financial crisis) becomes remarkably more palatable.

"There is a lot of positive development outside of the U.S.," says Stuart Schweitzer, managing director and global-markets strategist at JPMorgan Asset & Wealth Management. Add in the specter of towering deficits in the U.S. budget and current account, which could ultimately weaken the dollar, and the idea of diversifying overseas becomes even more attractive.

But some market watchers point out that the run-up in emerging markets has left stocks pretty darn pricey. The average price-to-book ratio for such equities has been in the neighborhood of 1.5 to 2 since the mid-1990s, says Schweitzer. Today that ratio is closer to 2.25. "We've had a correction," he says, "but they are still expensive relative to their own history." That's part of the reason Schweitzer is currently finding more value for his money in developed markets like Western Europe.

Of course, another cheap entry point may not be around the corner, so long-term investors may want to think less about timing and more about diversification. Financial planners recommend allocating as much as 5% to emerging markets but generally no more, considering the risk (think Nigeria or Venezuela). When culling the world markets, Clark Winter, chief global investment strategist at Citigroup Global Wealth Management, looks for macroeconomic drivers. The big one historically has been U.S. monetary policy, and domestic interest rates still hold a lot of sway over what happens abroad.

But increasingly other factors, like the combination of low wages and high education levels in India and the migration of human talent to Singapore, determine where capital flows. Winter also points out that in markets where corporate structure remains cloudy--China is a prime example--investors can more safely tap some of the excitement by owning multinationals. "You don't have to buy local stocks to do this," he says. A quarter of Procter & Gamble's sales come from emerging markets, for example, and China alone accounts for 14% of revenues at Anglo-Australian mining giant Rio Tinto. Buying more-established companies may seem less exotic, but for a cautious investor, it's a way to wade into the shallow end of the emerging-markets pool.