(MONEY Magazine) – Until recently, the case for emerging-market funds sounded so persuasive that it was almost rude to ask whether there was a catch. After all, developing economies such as Argentina, China, Indonesia and Portugal are expected to grow by an average of 5.9% annually through 1998 -- twice as fast as the U.S. And then there were those 1993 returns: The average diversified emerging- market portfolio vaulted 70% in U.S. dollars last year. There is a catch, of course, and it became clear early this year when many emerging markets suddenly submerged. Malaysia's and Thailand's exchanges fell 10% on profit taking, and Mexico's Bolsa, spooked by a guerrilla uprising, plunged 6% on Jan. 10 alone. Not surprisingly, some shortsighted skeptics then promptly denounced emerging markets as a fad. Don't listen to them. To be sure, last year's estimated $60 billion flood of cash from foreigners (around 15% of it from Americans) has driven some markets' prices well beyond reasonable levels, especially in parts of southeast Asia. "Although the long-term fundamentals are strong in markets such as Malaysia and Indonesia," points out Josephine Jimenez, co-manager of $650 million no-load Montgomery Emerging Markets, "many stocks are just way too expensive." Therefore, expect market declines of 10% to 15% in Asia this year, but don't let them distract you from those markets' long-term prospects. "Over the rest of the decade," says Ken Gregory, editor of the monthly No-Load Fund Analyst ($195 a year; 800-776-9555), "the annualized return for emerging-markets funds should be in the 12%-to-16% range, or about 50% more than the S&P 500." That's why we don't think you should hold off investing -- but you should tread cautiously. Parcel your money into these markets bit by bit, and limit your stake to 10% to 20% of your total equity holdings. In the table on the previous page, we've identified five promising funds for the long haul. All returned more than 58% last year; just as important, all possess two characteristics that limit risk: Diversification. Funds that invest in dozens of countries can better weather a squall in one or two markets than more concentrated funds can. For example, by spreading the $1.8 billion assets of Fidelity Emerging Markets (no load through May 31; up 82% last year) across 22 different countries, manager Richard Hazelwood was able to limit his portfolio's early-January slide to 4.6%. By contrast, funds focused in the Pacific Rim plunged 8%. All five of our picks spread their money across more than a dozen countries. Experienced management. Savvy stock picking is indispensable in emerging markets today, where unnoticed issues often provide the best values. "The indexes don't tell the whole story," says J. Mark Mobius of $1 billion Templeton Developing Markets (5.75% load; up 74.5% last year). "Once you get beyond the most heavily traded stocks in (Hong Kong's) Hang Seng index, 70% of the stocks are trading below their five-year highs." The problem is that no emerging-market fund has so much as a five-year / performance record; the oldest, $300 million Merrill Lynch Developing Capital (4% load; up 69% in '93), was launched in the fall of 1989. That's why we sought out fund managers who had extensive experience in developing markets before taking over their current funds. Montgomery's management team of Jimenez and Bryan Sudweeks, for example, has been researching or managing emerging-market portfolios since the early 1980s. Mobius and Merrill's Grace Pineda have each been exploring out-of-the-way markets for more than 10 years. Caesar Bryan and William Stack of $267 million Lexington Worldwide Emerging Markets (no load; up 63.4%) have also been managing international mutual funds since the late 1970s. Whichever fund you choose, keep your eyes firmly on the horizon. "My best investor is a six-month-old," says Templeton's Mobius. "He's not worried about what the Malaysian market did yesterday; he's focused on the long term. With that approach, we'll be able to make him a lot of money."

BOX: CORRECTIONS

The explanation of "annual performance analysis" in our February fund tables was erroneous. It should have read: "In these columns we compare a fund's return in each of the past five years against the best and worst returns earned by funds of the same type. The highest return gets a score of 100, the worst a 0. A score of 50 indicates that the fund earned a return exactly midway between the two." Also, Equity Total Return scores were skewed because of a miscategorized fund. For a free copy of the correct scores, call our data supplier, Morningstar Inc., at 800-820-8082.

CHART: NOT AVAILABLE CREDIT: Sources: Morgan Stanley Capital International, Morningstar Inc. and the funds CAPTION: FIVE WAYS TO PROFIT IN BRAVE NEW MARKETS Our five top fund picks take different roads to developing markets. While Fidelity has 25% of its assets in cash and bonds, Montgomery has only 3%. Templeton and Merrill have more than 20% in European markets; by contrast, Fidelity shuns the region.