I'm investing for the long term and I'd like to gain some exposure to emerging market equities. What's the smartest and most efficient way to do this? -- John B., Richmond, Va.
I'm glad to hear that you're going into this for the long haul. Too often, investors jump into emerging markets hoping for big profits, only to bail out when they get a taste of these stocks' extraordinary volatility.
For the five years from the beginning of 2007 through the end of last year, for example, emerging markets stock funds gained 37%, then lost 54%, soared 74%, climbed another 19% and then dropped 20%.
So while it's certainly possible to rack up some impressive gains by investing in emerging markets -- over the past 10 years they've generated annualized returns of 14%, more than double the Standard & Poor's 500 index's 6% -- you'll have to hold on through some gut-wrenching setbacks.
Assuming you're willing to do that, the right way to go about it is actually pretty simple. As I see it, you have two choices:
The first is to get all of your foreign stock exposure -- developed markets, emerging markets, the whole enchilada -- in a single fund, specifically a total international stock index fund.
Vanguard's Total International Stock Index fund, for example, owns some 6,300 stocks from more than 40 different countries. The fund's holdings mirror the stock market values, or market capitalization, of each country. So about 25% or so of the money you invest in the fund goes into stocks of emerging markets, while the rest ends up in shares of companies in mature, developed countries.
The price of this broad international diversity: 0.22% of assets a year, or $22 for every $10,000 invested. You can also get this fund as an ETF.
I like this all-in-one approach best because you don't have to make a decision about how to divvy up your money among individual countries or between developed versus emerging markets. The fund does it for you by piggybacking on the investing decisions of millions of investors around the globe.
But if you prefer to get your emerging markets stock exposure separately -- perhaps you already own funds that invest in developed foreign countries or you want a bigger dose of emerging markets than you'd get in a total international stock fund -- there's a second route: buy a stock fund that invests solely in emerging markets.
In that case, I think the best choice is a broadly diversified emerging markets fund that covers the full gamut of developing countries, such as an emerging markets index fund or ETF. If you go with this approach, just be sure not to take too big a helping of emerging markets stocks. Once these volatile shares get beyond more than 25% or so of your overall foreign stock stake, you'll be in for a much bumpier -- and scarier -- ride.
Of course, there are other ways to invest in emerging markets. Since investment firms have churned out so many narrowly focused funds and ETFs, you could satisfy your emerging markets jones by combining several funds that specialize in regional emerging markets (Latin America, Eastern Europe, Asia) or in individual countries (Brazil, Indonesia, South Africa). But then you'd also have to decide how much to put in each region or country.
Unless you have special insights into the future growth prospects for each market -- and are capable of judging whether you're paying a reasonable price for that growth -- you'd be winging it.
So I recommend you take one of the options I've outlined and avoid the guessing game of sifting through specific emerging markets to identify future winners and losers. And once you've invested, strap yourself in for a long, sometimes bumpy, ride.