Smart investors keep an eye on what the crowd is doing, but they don't necessarily follow the crowd. With so many people chasing yesterday's performance, and continuing to buy into the same emerging-market investments, is it time to start thinking like a contrarian and looking for the exits?
A long trend
Yesterday, Morgan Stanley released figures on where ETF investors were putting their money during the most recent week. Among the ETFs with the most money flowing into them, the top three were all oriented toward emerging markets. The Vanguard Emerging Markets Stock ETF (NYSE: VWO ) topped the list with close to $2.9 billion in inflows, with iShares MSCI Emerging Markets (NYSE: EEM ) and the single-country targeted iShares MSCI Brazil ETF (NYSE: EWZ ) rounding out the top three.
That continues a trend that's been going on far longer than just a week. During the entire third quarter, the same Vanguard and iShares emerging market stock ETFs took in more than $10 billion. What's drawing so many investors into emerging-market investments?
Where the returns are
The big move of money into emerging-markets ETFs looks like a classic response by investors: looking at past performance in making future investment decisions. Over the past two years, U.S. stocks have put in decent performance, with the S&P 500 rising at a 17% annual clip from its depressed levels during 2008's market meltdown. But the returns over the same period for emerging-market ETFs are closer to 40% per year, reflecting a much more rapid recovery from March 2009's market lows.
It's easy to conclude that the crowd is making a huge mistake in chasing emerging-market performance. But just as bubble-talkers have been frustrated by the persistence of the bond market in avoiding a sharp downturn in prices, emerging-market skeptics have a long track record of being wrong about an inevitable drop in share prices. Since 2000, one emerging-market index fund is up an average of 14% per year, while the S&P has been just about flat. And although emerging-market stocks fell just as sharply as U.S. stocks during the financial crisis, their greater resiliency in its aftermath surely must have confounded bears.
Moreover, another data point suggests that investors are particularly focused on emerging markets. According to Morgan Stanley, investors actually took money out of the SPDR Gold Trust (NYSE: GLD ) during the third quarter, even though the fund has seen similarly large price gains both recently and over the longer term. If investors were simply chasing performance, you'd expect to see similar inflows into this ETF. With gold and ETFs, though, it's possible that part of the move is due to investors replacing their SPDR Gold with the similar iShares Comex Gold Trust (NYSE: IAU ) and Central Fund of Canada (AMEX: CEF ) , or the more volatile mining ETF Market Vectors Gold Miners (NYSE: GDX ) , which often moves more strongly when metals prices rise.
An essential component
Even if emerging markets are overhyped right now, they serve a useful purpose in investors' portfolios. Just as high-growth companies can supercharge a diversified portfolio of stocks, exposure to high-growth emerging-market countries can spice up a global investment portfolio.
Nonetheless, it does make sense to set a reasonable asset allocation to emerging markets, and then be sure to rebalance periodically. Rebalancing forces you to take some profits during periods of strong performance like we've seen lately, locking in some of your gains and reducing your risk in the event of an emerging-market correction.
When markets look overheated, the natural contrarian reaction is to run for the hills. But often, upward trends last far longer than you might expect. Usually, the better solution is to keep some of your money invested, but to make sure that you rebalance to ensure that your overall risk level is where you want it to be. That way, you're well-positioned no matter what happens in the future.