The US stock market has been a big disappointment to investors for more than three years. At the same time, falling interest rates have cut the payments people receive from fixed-income investments. So many investors have turned to one of the few bright spots: emerging markets and emerging-market bond funds.
In spite of the increased potential risk of these funds, investors put more than $580 million into emerging-market bond funds in the first three months of this year, according to AMG Data Resources in Arcata, Calif. That's more than was invested in all of 2002, when these funds took in some $538 million. Through mid-May, inflows added up to more than $1 billion, AMG reports.
The reasons are easy to understand, says Todd Henry, a portfolio specialist at T. Rowe Price in Baltimore.
"People are looking around and saying 'Where can I get good returns?' The United States had a tremendous run in the 1990s, but it's given a lot back in the past three years," Mr. Henry says. "Some good things are going on in Europe, but we don't see much growth there for the next couple of years. So, the search for higher yields has led a lot of people to emerging-market bonds."
For the most part, these funds have rewarded investors' confidence: For the first five months of this year, the average emerging-market bond fund returned 19.8 percent, according to Morningstar Inc., in Chicago. For the three years ended May 30, funds in this group averaged over 18.1 percent. That contrasts with the Standard & Poor's 500 index of large US stocks, which returned 8.6 percent in the first five months of this year, but fell 9.4 percent annually over the past three years.
Analysts point to a number of reasons for the strong performance of emerging markets. Russia, for example, is benefiting from steadily increasing oil exports. Several Eastern European countries are cutting their deficits and taking other steps to get their economic house in order as they prepare to join the European Union. In Asia, China's robust economic growth is not only benefiting that country, but is helping other markets in the region that trade with China.
In Latin America, yields on Brazilian bonds have surged more than 10 percent since Luiz Inácio Lula da Silva was elected president last fall. Looking at Mr. da Silva's statements in previous campaigns, many investors expected him to drastically increase government spending - and debt - to revive the economy. Instead, he has pleasantly surprised global investors by pursuing a stricter economic plan than investors had expected.
But fund experts and financial planners caution that that while emerging-market funds have performed well in recent years, their continued strength depends on factors that can change quickly. For example, the Turkish government refused to allow that country to be used as a staging area for the war with Iraq. As a result, an expected financial aid package from the International Monetary Fund was drastically reduced, and prices of Turkish bonds declined.
Meanwhile, a lengthy strike in Venezuela has failed to oust President Hugo Chávez, but it has sharply reduced oil exports, an important source of revenue for Venezuela. "These funds can add some spice to a portfolio," says William Rocco, a senior fund analyst at Morningstar. "But they are very volatile."
In fact, Mr. Rocco says, investors may not need an emerging-market fund in their portfolio at all, if they already have a foreign bond fund.
Many international bond funds, as well as global funds that invest in the United States and overseas, already have some emerging-market exposure. For example, he notes that some of the Templeton Funds, such as Templeton World Fund and Templeton Foreign Fund, have relatively large allocations to emerging markets.
"So anybody who's thinking about buying one of these funds should make sure they have a need for a secondary international fund," Rocco adds.
Still, some advisers do see a need for these funds. "We have been using emerging-market bond funds in our clients' portfolios for several years,'' says Steven Enright, a certified financial planner in Westwood, N.J. Because these funds do not perform in lockstep with their developed-market counterparts, "we always felt emerging-market bond funds added a certain amount of diversification to a portfolio," Mr. Enright adds.
Even he thinks investors should be aware, however, of the potential risks of emerging markets - and limit their exposure. Enright says he would put no more than 10 percent to 15 percent of a client's fixed-income investments, or about 5 percent of the total stock-and-bond portfolio, in emerging-market funds.
"These funds can be volatile, so you're playing with fire if you go over that," he says.