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For years, investors have counted on emerging-market stocks to deliver consistent high-octane growth for their portfolios. Now, though, emerging markets are letting faithful investors down, and it's far from clear whether they'll bounce back or continue falling as the global economy starts to see new signs of stress.
What goes up ...
Throughout a lost decade for U.S. stocks, emerging markets seemed to defy financial gravity. Thanks to extremely strong economic growth rates in China, India, Brazil, and Russia throughout much of the past decade, emerging-market stocks vastly outperformed not only their U.S. counterparts but also stocks of other developed countries. Even as many large economies around the world suffered substantial contractions during the 2008-09 financial crisis, China and Brazil merely saw red-hot growth rates slow a bit.
But even boom times can't last forever. Emerging-market countries face a host of new challenges:
- In China, efforts to try to ease the economy to a slower, more sustainable growth rate have become increasingly difficult. With some local real estate markets in Hong Kong and mainland China nearing bubble status, a disruption in housing could cause similar problems to what U.S. investors have seen domestically.
- India is dealing with even more problems, including huge inflationary pressure. The nation's central bank raised interest rates last week for the 10th time in 15 months, yet the country's stock market is down 14% for the year and doesn't seem likely to turn around soon.
- Brazil's economy is somewhat insulated from the troubles in Asia, although the nation is a key source of natural resources for China. Yet like its peers, the Latin American giant is fighting inflation and an overheating economy.
- Russia's growth has been less dramatic than that of China and India. The country remains perilously dependent on its natural-resource riches, though, and is still fighting an image of being unfriendly to foreign business investment.
Stocks have followed suit. After a big rally last fall, the iShares FTSE China 25 Index (NYSE: FXI ) is below late 2009 levels and has seen a loss for the year. The closed-end India Fund (NYSE: IFN ) has seen a big loss since January, and the Brazilian iShares MSCI Brazil (NYSE: EWZ ) is also struggling with the turn of economic events in its home country. Even the closed-end Templeton Russia & Eastern European Fund (NYSE: TRF ) has not only seen losses but also trades near its biggest discount of the year.
How to make money in emerging markets
Perhaps the best lesson from recent events comes from the realm of Chinese small caps. It's easy for investors to think that when it comes to investing in an emerging stock market, which company you pick is more or less unimportant.
But nothing could be further from the truth. While smallish companies Yongye International (Nasdaq: YONG ) and Harbin Electric (Nasdaq: HRBN ) have been lightning rods for major allegations of questionable financial practices, other individual emerging-market stocks have thrived in the current environment. Similarly, relying on an ETF like Vanguard MSCI Emerging Markets (NYSE: VWO ) gives you exposure not only to the best emerging-market stocks that you want in your portfolio but also to plenty of others that you may not want to own.
Don't be scared
For good or ill, the easy money in emerging markets has already been made. Hopefully, you got in on some of those profits early on.
Going forward, though, the key is to understand that as with any stock market, emerging markets will have some winners and some losers. Compared with a rising tide that lifts all ships, it's a little harder to pick through the bad stocks to focus solely on the good. In the end, though, your investing results will be a lot better for having gone to the extra effort.
Despite the danger of using exchange-traded funds to invest in emerging markets, there's one ETF that has what it takes to make our cut. Find out which one in our free special report, "3 ETFs Set to Soar During the Recovery."