Stupid investment of the week: Emerging markets mutual funds

By Chuck Jaffe

Published: June 4, 2006

For many investors, diversification is more than an investment strategy. It's an alibi, an excuse to chase what's hot under the guise of doing something good for an investment portfolio.

Over the last few years, that has been particularly true of investments in emerging markets, developing economies that often deliver feast-or-famine performance. Compared with many domestic funds, emerging markets have seemed like an all-you-can-eat buffet for about three years.

The result has been investors plowing money into those funds, largely in the name of diversifying a portfolio rather than chasing what has been hot. But with many observers thinking emerging markets could soon be leaving investors hungry again, it's time to recognize that emerging markets mutual funds have become a Stupid Investment of the Week.

Stupid Investment of the Week highlights the problems and flaws that make a security less than ideal for the average consumer, in the hope that spotlighting danger in one situation will make it easier to find elsewhere. While obviously not a purchase recommendation, neither is this column meant to be an automatic sell signal, as there may be times when unloading a worrisome investment simply compounds the trouble.

In today's case, with a blanket concern over an entire genre of fund, that's particularly true, as the problem with emerging-markets funds and average investors has at least as much to do with the person buying the fund as it does with the funds themselves. There are plenty of outstanding emerging markets funds that might make sense for an investor, if held in moderation and for the long haul.

The problem is that investors don't seem to want to use the funds that way.

Performance has a lot to do with that. According to Lipper Inc., the average emerging-markets fund is up 39 percent over the last 12 months, and has an annualized average gain of 35 percent since the end of May 2003.

Results like that have attracted money, but a lot of it has come in the unlikeliest of places.

A Hewitt Associates study of investor allocations to emerging-markets funds in their 401(k) plans shows that just under 1 percent of retirement-plan assets are held in emerging-markets funds, but for investors who do hold positions in developing countries, those holdings are disproportionately large.

The Hewitt study, released Thursday, showed that for investors who hold emerging-markets funds in their retirement portfolio, almost one in four has at least 20 percent - and as much as 50 percent - of savings tied up in this type of fund. The less time an employee has in the plan, the bigger percentage is committed to emerging markets.

"The investors who have emerging-markets funds are surprisingly concentrated there, says Lori Lucas, who headed the Hewitt research. "It's performance that is drawing them, not diversification. They see performance sheets for the last three years and are impressed by what they have seen but don't realize that the volatility cuts both ways.

In fact, it has been cutting the wrong way for about a month now. According to Lipper, the average emerging-markets fund has lost almost 10.4 percent in the last month. That hasn't been enough to wipe out the impressive gains, but plenty of experts are concerned that the performance trend will look more like the month of May than the last three years in the near future.

"Everybody has been jumping in at the wrong time, says Stephen McKee, editor of the No-Load Fund Selections and Timing Newsletter, which sold out of its 20 percent stake in emerging markets in April. "These market conditions are horrible, and if you didn't start selling a month ago, you should get off your hands and scale back now.

The conditions are bad not just because of interest-rate fears, which have been responsible for the recent tailspin, but also because emerging markets tend to get - and then surrender - assets in great big gushes, making the funds inherently volatile.

That big flow of cash has already started, and it's moving in the wrong direction. Hewitt research showed that between May 10 and May 23, 4.5 percent of the retirement-plan money that was in emerging-markets funds transferred out, with money going into investments as conservative as stable-value funds and guaranteed investment contracts.

"That's not an asset-allocation decision, says Lucas, "that's people heading for the hills after seeing some of the volatility.

Most financial experts can make a solid case for owning investments that plow into the markets in Latin America, India, Russia and elsewhere in the economically developing world, but they preach moderation.

A common rule of thumb suggests that an investor keep between 15 percent and 25 percent of assets in international funds, but with no more than one-third of that allocation in emerging markets.

"For the average investor, my vote would be that they opt for a broad international fund and let the manager decide when it's time to get in or out of emerging markets, says Christine Benz, director of mutual fund analysis for Morningstar Inc. "Even some domestic funds have been making big lays into India and other emerging markets. The big thing is not to load up too much on emerging markets, especially now when it looks like they are about to suffer.

The hard part for investors may be scaling back on funds that have been terrific performers in recent years. Rebalancing a portfolio - taking profits from winners and reinvesting them into the asset categories that have been lagging - is a good way for average investors to try to buy low and sell high. It also protects an investor against significant and steep declines that occur in volatile asset classes.

In the end, emerging markets funds have been solid investments - and will be again - but investors need to guard against committing too much to them now simply because they have been hot recently. With a downturn having already started and seeming to be picking up speed, investors throwing big chunks of their holdings toward emerging markets aren't making a choice towards diversification, they're making a mistake.

YOUR FUNDS: Distributions look good to some, bad to others
Here are three recent queries from the minds of fund investors:

Question: I own Fidelity Magellan and read on a message board about how a lot of people are unhappy that the fund had a big capital gains payout. I thought capital gains meant I was making money. Is this really so bad? -- Mark in Keller, Texas

Answer: In early May, Fidelity Magellan (FMAGX) paid shareholders $22.36 per share in long-term capital gains and dividends. That was 18 percent of the fund's value, Magellan shares declined by the amount of the distribution - scaring the bejeepers out of a lot of shareholders - although most investors simply reinvested the proceeds, ending up with the same dollar amount invested in the fund. They own more shares, making up for the lower price and wiping out the perceived loss.

Mutual funds are "pass-through securities, meaning that whatever tax burdens they rack up get passed to shareholders for payment. Funds realize capital gains when they sell securities at a profit. Gains build over time and most funds subtract out losses and make a distribution late in the year; if gains are particularly big, however, a special payment like Magellan's could be used.

Investors who hold a fund in a taxable account owe taxes on those distributions. When a fund is in a tax-advantaged account - the way most shareholders hold Magellan - distributions are simply part of the long-term growth, which gets taxed when the shares are sold, if ever.

Magellan's distribution was mostly caused by moves made by new manager Harry Lange, who took over the fund last Halloween and has been revamping it to fit his preferred management style.

About the only people suggesting the big distribution payout was bad are those who will owe taxes on it next year, plus shareholders who take distributions in cash and who now have a big wad of cash to find a home for.

Barring those conditions - and many investors take steps to minimize those tax headaches - distributions are nothing to get too excited or upset about. The easiest way for a fund to avoid gains is to make no money, but big gains don't always mean a fund is great. For proof, look at Magellan itself; while racking up that enormous gain, the fund has lagged the Standard & Poor's 500 index for years.

Question: Are there any fund companies that let me rebalance my fund account automatically, so that when something grows big I can take profits without having to watch my funds every day? -- Hal in Renton, Wash.

Answer: Probably not, but you shouldn't be watching your funds and waiting to pounce every day anyway.

Rebalancing is the process of harvesting winners and redeploying the money into other areas so that a portfolio stays at target allocations. It's a sound idea that fits into any buy-low, sell-high strategy.

Many firms allow systematic withdrawals, letting shareholders pull money from one fund and move it to another at regular intervals. That's not perfect for rebalancing, however, because the pull-out occurs on a regular basis, rather than when a fund has gone on a hot streak and gotten to where it represents too big a chunk of the portfolio.

Another option from some firms is "cross reinvestment. This allows shareholders to take income and capital gains payouts from one fund and reinvest them in a sister fund (or in a fund offered in the same brokerage plan). It's a bit more random than the systematic withdrawal (witness the Magellan situation), so it's hard to know if it will be sufficient to really rebalance the portfolio.

Financial advisers frequently rebalance portfolios as part of their services, but most also caution against making changes too often.

Move the portfolio every time it has a fund that is 5 to 10 percent above or below its target allocation. That shouldn't happen too often; if it doesn't occur on its own, rebalancing once every two years should be sufficient.

Question: How many funds should I own? I just started investing and I have four now. -- Melissa in Oak Park, Ill.

Answer: Worry more about the types of funds you own than how many. The typical investor can achieve their financial goals with somewhere from four to 12 funds.

If you own four funds that invest in the same fashion - say all large-cap stocks - you have what experts call a "closet index fund, meaning you are likely to get the return of an index fund, even though you are paying four managers to actively run your money.

Diversifying requires buying different types of funds, but for a beginning investor it can be as simple as one large-cap, one small-cap, one international and one income or money-market fund. If you don't want to make the portfolio drastically more complicated, keep it simple; in the alternative, turn to life-cycle or asset-allocation funds that are designed to be a one-stop shopping choice for investors who don't want to wrestle with owning a lot of funds.

JAFFE'S SHORT COURSE: Turnover ratio
A term with different meanings depending on its use, turnover ratio is most commonly used in mutual funds but also applies to business inventories.

In mutual funds, turnover represents the percentage of a fund's assets that have changed over a year. High turnover funds tend to have higher expenses, as well as higher hidden costs, the trading fees associated with that portfolio movement, and are often less tax-efficient than low-turnover funds.

On the inventory side, turnover ratio is the cost of goods sold divided by the average inventory during a given time period. The result is the number of times a company's inventory is replaced during that period. The higher the number, the better the signal that the company is producing and selling its goods quickly.

FINANCIAL HOUSEKEEPING: Safeguard your wallet
The weeks leading up to summer with the start of vacation travel, or the beach or carefree days that frequently come with time off is a great time to update your "wallet protection."

If your wallet is lost or stolen, the missing cash can be a minor concern compared with the potential problems from fraud and identity theft. To avoid those woes, do not carry anything in your wallet that includes your Social Security number and keep an inventory of what you do keep in there.

To update that inventory, take your wallet to a copy machine, lay all cards and identifications on the machine and make copies of both sides. Put the copies in a safe place. If you lose your wallet, you'll know exactly what is missing, the account numbers affected and who to call to report the cards missing.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.