Emerging markets have been on something of a tear over the past year, and experts say they have more room to run. That’s good news for investors who have arrived late to this party.
The MSCI Emerging Markets Index, which tracks stocks in 24 countries — including China, Russia, Poland and Peru — is up more than 25 percent this year. That compares to gains over the same period of less than 20 percent for the Standard & Poor’s 500 index, excluding dividends.
What’s behind this stellar performance? First, emerging markets are cheap compared to the U.S. stock market.
“Valuation for emerging markets is at a discount to the U.S.,” says Jack Ablin, chief investment officer at BMO Private Bank in Chicago.
For instance, U.S. stocks cost 18 times forward earnings, whereas emerging market stocks cost 12 times projected earnings, according to Yardeni Research.
[See: 10 Great Ways to Buy Emerging Markets.]
Momentum is the next thing Ablin notices about the category because investor sentiment is putting the wind at the backs of emerging market stocks. Known as momentum investors, these Wall Street professionals pursue assets that are outperforming others. When returns from emerging markets started outpacing those of U.S. markets, momentum investors jumped on the bandwagon, helping to propel the category’s stellar returns.
Ablin expects that momentum to continue for a while. Large-cap U.S. stocks and emerging markets stocks tend to take turns outperforming each other in periodic cycles lasting years at a time, he says.
Room to grow. What’s noteworthy about emerging market economies is that, even though they’re getting rich quickly, large portions of the population are underserved, giving companies there huge potential for long-term growth. This is known as under-penetration.
“If penetration levels are low relative to other emerging market countries or the developed market world, one should search for companies exposed to that long-term potential,” says David Park, a portfolio manager at asset manager Carmignac.
He points to the Indian banking industry as one area that is especially under-penetrated, and the country also has low levels of consumer debt.
Thanks to India’s growing economy, more Indian households will enter the middle class, which should lead to more consumer loans for homes and cars, he says. As a result, he expects bank loans and other credit to grow faster than the rest of the economy for at least 10 years, benefiting the stocks of Indian banks.
Not for the faint-hearted. Emerging markets have economies that are still developing, and investors should be prepared for a turbulent ride. “People need to realize that these markets are more volatile,” says Richard Rosso, director of financial planning at Clarity Financial in Houston, who adds that he is invested in such markets.
Because of that volatility, stocks in emerging markets can move up and down a lot more than they would in a developed market like the U.S. Those wild swings in stock prices can mean much larger gains than U.S. stocks and also steeper losses, which can make small investors anxious, he says.
[See: The Fastest Ways to Lose Money in the Stock Market.]
Invest indirectly. Every emerging market country has its own stock market with its own rules and regulations, not to mention currencies. Consequently, small investors won’t want the hassle of investing in foreign stocks directly. Mutual funds and exchange-traded funds are a much better way to invest, even for experienced investors.
The American Funds New World (ticker: NWFFX) invests in large-cap stocks with exposure to developing markets and has a heavy weighting in Asia. The fund has annual expenses of 1.03 percent, or $103 per $10,000 invested, and a low minimum investment of $250. Goldman Sachs Emerging Markets Equity ( GEMAX) invests in large and medium companies in a variety of countries. Its annual expenses are 1.66 percent, or $166 per $10,000 invested, and a $1,000 investment minimum.
Each of the following exchange-traded funds are named for the indexes they track, which include a broad mix of large-cap and midcap stocks. The iShares MSCI Emerging Markets ( EEM) has annual expenses of 0.72 percent, or $72 per $10,000 invested, while the WisdomTree Emerging Markets Dividend ( DVEM) charges 0.32 percent, or $32 per $10,000 invested.
Allocation amount. Ablin says the standard suggestion is to make approximately 7 percent of your stock portfolio emerging market stocks. So a person with $100,000 invested in stocks of all types should put $7,000 in emerging market stocks.
[See: 10 Long-Term Investing Strategies That Work.]
More adventurous investors may want to allocate a larger portion, say, 10 percent. Either way, emerging markets should be a small part of a balanced portfolio.
More from U.S. News
7 ETFs That Let You Invest With the ‘Smart Money’
8 ETFs for Investors Who Love Value
9 Under-the-Radar Ways to Buy Financial Stocks
Why Emerging Markets Are a Good Bet Now originally appeared on usnews.com
