BARRON'S COVER SATURDAY, JANUARY 8, 2011

Prosperity Beckons By MICHAEL SHARI

Fund investors have gotten the message that emerging economies are poised for more growth. So now what do they do?

The story line is compelling. Emerging economies from Chile to China to the Czech

Republic have grown at a 12% annual clip since 1995 and now make up more than a third

of the world's gross domestic product. By the end of this decade their share should exceed

half. The rapid growth—and expectations of more—helped drive their stock markets 130%

off their lows of November 2008, easily topping the Standard & Poor's 500's 47% gain in

that time. The developing markets make up 13% of the global stock market, a portion that

looks sure to rise over time.

"This is a transition to an emerging-market-led global economy in the deepest sense," says

Jonathan Garner, chief emerging-markets equity strategist at Morgan Stanley in Hong

Kong.

Curtis Parker

Fund investors have started to get the message. They nearly fell over each other in plowing

a record $54 billion into emerging-markets funds in the first 11 months of 2010. With such

a rush, no doubt some money got lost along the way.

So where are shareholders supposed to direct their enthusiasm? How much of their

personal portfolios should be devoted to the world's growth markets and what are their

options? And, in light of some stretched valuations and worries about inflation, what's a

reasonable emerging-market equity return for 2011?

Depending on their age, investment goals and income needs, investors probably should

have an amount roughly equal to emerging-markets' global equity share, or 13%, in their

stock portfolios, says George Hoguet, a senior portfolio manager and emerging-markets

strategist at State Street Global Advisors in Boston. "The most important decision is the

asset-allocation decision, and then the second-order decision is which vehicle to use," says

Hoguet, whose firm manages $1.9 trillion in assets globally.

MOST INDIVIDUAL INVESTORS ARE well below the target, but Hoguet advises

against trying to reach the destination overnight. "Straight lining" your allocation based on

recent historical data and experience is a mistake, he says. Adds Joel Dickson, senior

investment strategist at Vanguard: "Rear-view-mirror investing can cause problems,"

particularly since the recent past has been so extraordinary. Last year, for instance, the

MSCI Emerging Markets Index gained 16.36%, versus 15.06% for the S&P. A number of

specialists say a return, including dividends, of roughly 10% this year is the most likely

outcome and takes into account a possible correction along the way.

Although hardly the only vehicle, an actively managed global emerging-markets mutual

fund is probably the best mode of transport for inexperienced travelers. Investing in these

markets has changed in recent years as individual stock-picking has become more

important than country selections. There are promising stocks in Brazil, China, Taiwan

and even Russia, though some of these markets themselves face problems. As you can see

from our table, A Stellar Year for Emerging-Markets Funds, a savvy portfolio manager can

make a big difference.

"It's a way to get exposure to the broad trends that are benefiting all emerging markets,

spread your risks across the whole globe, and try to take advantage of the best companies

in emerging markets without having to worry about particular regional risks," says Robert

von Rekowsky, portfolio manager of the Fidelity Emerging Markets Fund (ticker:

FEMKX), which has $5 billion in assets and gained 18.36% last year.

IN THEORY, YOU CAN BUY ALMOST any public stock, whether it trades in Prague

or Jakarta, through a broker. The reality is a lot more complicated.

There is little Wall Street research on many stocks and wide gaps in bid and asked prices

to buy them. Then there are the chronic emerging-economy woes of opaque markets,

limited press freedom, minimal minority-shareholder rights, abrupt regulatory changes,

punitive taxes and volatile currencies. In the Shanghai Stock Exchange, foreign investors

must go through brokers that are licensed as Qualified Foreign Institutional Investors—

and charge a commission of about 1.5% on trades, compared with 25 basis points (0.25%)

in Hong Kong, where many of the same mainland Chinese companies are listed.

You could also find yourself competing with day traders and other amateurs who, unlike in

the U.S., account for the majority of stock trading in remote countries at odd hours when

you're fast asleep, says Frederick Jiang, portfolio manager of the Ivy Pacific

Opportunities Fund (IPOAX), which has $825 million in assets. "A professional will

have a better chance of beating the index," says Jiang.

If you insist on picking stocks, the safest bet is a U.S.-based multinational that derives a

chunk of its sales from emerging markets. Dave Donabedian, chief investment officer of

Atlantic Trust, the high-net-worth arm of fund manager Invesco, likes H.J. Heinz (HNZ),

which derives about 16% of its sales from emerging markets and expects that number to

grow to 25% over the next few years. Donabedian also likes Nike (NKE), which gets 13%

of its Nike-brand revenue from emerging markets. He sees that number rising this year.

Most of the focus in emerging-markets funds today is on identifying and comparing stocks

of almost any cap size and investment style to fit global investment themes. Fund

managers have the power to pit, say, Brazilian apparel retailer Cia

Hering (HGTX3.Brazil) against Chinese clothing storeGiordano

International (709.Hong Kong) in the same GEM fund as a play on a middle class

emerging and making purchases in secondary cities. Larger asset managers also enjoy

superior buying power, particularly those affiliated with investment banks that have

proprietary trading desks like Goldman Sachs or JPMorgan Chase, not to mention their

standing armies of analysts in offices around the world.

Your GEM manager should have a solid long-term track record for adding value. On an

annualized basis, for instance, the $206 million Aberdeen Emerging Markets Fund

(GEGAX) is up 16.55% for the 10 years through Dec. 31 and the Oppenheimer

Developing Markets Fund (ODMAX) has gained 19.19%. Both funds beat the MSCI

Emerging Markets Index, which was up 13.18% for the decade.

As a complement to a GEM fund, you could add a regional fund if you're convinced one

area will grow faster than others. A fund that's done particularly well is the Matthews

Pacific Tiger Fund (MAPTX), which is run by a team of analysts who circulate only

within Asia from the firm's base in San Francisco. It's averaged a gain of 16.98% annually

over the past 10 years, beating the 12.54% return for the MSCI Emerging Markets Asia

Index. Because these markets are so variable and local knowledge hard-won, a good

manager is generally worth the added cost.

That's especially true for country-specific funds, which also can be used to augment a GEM

fund if you want to make a specific bet. The $464 million ING Russia Fund (LETRX), in

posting a remarkable average gain of 29.35% a year over the past decade, has dramatically

beaten the MSCI Russia Index's 19.63% return. Last year, the fund bet on the strength of a

Russian natural-gas supplier that sells only to the domestic market,Novatek (NVTK.U.K),

which soared 81%. Competitors such as Gazprom (OGZD.U.K) and Lukoil (LKOD.U.K)

that depend on exports to Western Europe faced punitive Russian taxes and didn't fare so

well. The fund's holdings trade at 11.3 times forward earnings.

"A manager not dedicated to Russia would really have struggled," says Angus Robertson,

the fund's portfolio manager. "A lot of investors have burned their fingers in this market."

Similarly, the MSCI China Index delivered a measly 2.32% return last year, but the $56.5

million Aberdeen China Opportunities Fund (GOPAX) raked in a 27.94% return by

snapping up Hong Kong-based companies that were undervalued because they were "not

as sexy" as mainland China companies, says Nicholas Yeo, head of Hong Kong and China

equities at Aberdeen.

If you want to concentrate your risk in bigger, more mature markets, you might consider

BRIC funds, which confine themselves Brazil, Russia, India and China.

But the more focused the theme, the higher the risk. Last year, the MSCI indexes for China

and Brazil each grew less than 4%, while India was up nearly 20% and Russia gained more

than 17%. "One of the themes in emerging markets more broadly is that the smaller

markets such as Chile and Malaysia have done perhaps better than the larger ones,

including China and Brazil," says Richard Flax, portfolio manager of the $850

millionGoldman Sachs BRIC Fund (GBRAX), which rose 10.39% last year. As evidence

of this trend, the $648 million Goldman Sachs Emerging Markets Equity Fund

(GEMAX), which Flax also runs, jumped 16.15%. The lesson here is to allocate your assets

to small countries as well as the BRICs, says Flax.

If your goal is to match the overall growth of these expanding markets—and save money

on fees—then index funds are one answer. Another advantage of an index fund is that an

investor can make regular payments to it without facing a broker fee as one would with an

exchange-traded fund, which is also an indexed product, notes Deborah Fuhr, global head

of ETF research at BlackRock in London. Then again, an ETF allows you to withdraw

money without paying an early redemption fee as one would with an indexed mutual fund,

not to mention tax efficiency, daily transparency and the ability to trade intraday. One of

the largest index funds is the DFA Emerging Markets Value Portfolio, which has

about $13.3 billion in assets. Two of the largest ETFs are the Vanguard Emerging

Markets Stock ETF (VWO), with $43.3 billion, and the iShares MSCI Emerging

Markets Index Fund (EEM), with $46 billion.

ETFs and index funds can be used to fill gaps in a GEM's portfolio or to make specific bets.

"Most investors use both active and passive funds. There isn't just one way to get at this,"

says Anthony Rochte, senior managing director of SSgA.

Over the past year, there's been an inverse relationship between fees and returns,

according to SSgA data. During the first 11 months of 2010, active funds returned an

average of 12.46%, while indexed mutual funds returned 7.42% and ETFs returned

13.44%. The average net expense ratio for an ETF is 0.70%, compared with 0.79% for an

indexed mutual fund and 1.82% for an actively managed mutual fund. The shortfall in

index performance is due to their small number and generally limited focus.

Regardless of the vehicle you choose, 2011 will present challenges that many may not have

expected when flocking to emerging markets last year, notes James Donald, portfolio

manager of the $181 million Lazard Developing Markets (LDMOX). Inflation is rising

in much of the emerging world, mainly because commodities prices are on the upswing

and domestic demand is growing so fast that it's outpacing exports as a driver of economic

growth. Interest rates went up in China and India last year and, notes Morgan Stanley's

Garner, they will continue to rise this year.

AS A RESULT, EMERGING MARKETS ARE likely to grow 5% to 10% this year.

Adding in a dividend yield of about 2%, comparable to last year, gives you a return in the

high single-digits or low double-digits, predicts Joanne Irvine, head of emerging markets

ex-Asia at Aberdeen Asset Management in London.

Irvine points out that last year's economic strength, abetted by inflation, came off a low

base after the financial crisis. The high end of her estimate, she says, would reflect

stronger U.S. and European markets that may recapture some fund money now going

abroad, more quantitative easing by the U.S. Federal Reserve and the possibility of capital

controls in emerging markets, such as those that Brazil pledged on Jan. 5 to curb the rise

in its currency.

At the same time, cheap stocks—and by extension cheap funds—are harder to come by.

Seven months ago, emerging-market equities were trading at an average of 9.5 times

forward earnings, Morgan Stanley estimates. They are now trading at an average of 11.9

times estimated 2011 earnings, compared with 14 for the S&P 500, according to

Bloomberg consensus data. And there is scant evidence that emerging markets will get

cheaper; they trade their 23-year average of 11.5 times earnings since 1988. The holdings

of GEM funds trade an an average of 15 times last year's earnings, and 13.5 times

estimated earnings for the current fiscal year.

None of this is cause for alarm and any corrections could be used to build positions. Irvine

and other fund managers, including Gonzalo Pangaro, portfolio manager of the $5.5

billion T. Rowe Price Emerging Markets Stock Fund (PRMSX), still see plenty of

room for growth in emerging-market stocks this year, particularly in Latin America. "We

are very positive and overweight in Latin America," she says.

Both managers own Brazilian banks, which they consider some of the world's best. The

average return on equity for a Brazilian bank exceeds 20%, says Irvine. They are also

posting loan growth of 15% to 20%. And the banks trade at 10 times 2011 earnings, a

discount of about 16% to emerging-market stocks on average, notes Pangaro.

"I like Brazilian banks that performed badly in 2010," says Pangaro. One of the T. Rowe

fund's largest positions in Latin America is Itau Unibanco Holding (ITUB), which was

up by just 5.1% last year but has rocketed 515% higher since January 2004. Pangaro

blames last year's performance on Brazil's tighter monetary policy, which should end some

time this year. "Once we get to that point, Brazilian banks will continue to perform," he

says.

Irvine favors Banco Bradesco (BBD), which was up 12% last year after a stellar rise of

more than 700% since Aberdeen bought it at the beginning of 2004. "I would expect

Bradesco to do very well this year," she says.

Putting the S&P to Shame

While the main barometer for the U.S. market has barely budged in the past decade, the world's

developing economies have offered investors double-digit annual returns on average.

REGIONAL PERFORMANCE 1-Year 3-Year 5 -Year 10-Year

BRIC 7.25% -6.99% 13.94% 14.75%

EM (Emerging Markets) 16.36 -2.58 10.26 13.18

EM Asia 16.57 -3.05 10.35 12.54

EM Eastern Europe 13.72 -14.71 1.96 15.43

EM Far East 16.12 -2.49 9.59 12.22

EM Latin America 12.07 1.59 16.50 17.55

Jordan, Egypt & Morocco 8.230 -11.16 3.37 NA

China 2.32 -7.91 17.80 11.35

India 19.41 -5.78 16.36 17.19

Indonesia 31.19 7.11 25.74 26.74

South Korea 25.29 -2.15 6.24 17.95

Malaysia 32.51 3.49 15.87 10.92

Philippines 30.29 -1.19 15.65 9.10

Taiwan 18.32 2.06 5.45 5.01

Thailand 50.81 8.39 13.89 19.17

Brazil 3.78 -0.92 19.10 17.29

Chile 41.82 17.30 19.77 17.01

Colombia 40.75 21.57 17.55 38.73

Mexico 25.99 2.61 10.42 16.02

Peru 49.24 13.33 32.72 30.69

Czech Republic -7.40 -15.27 3.65 20.23

Hungary -10.70 -16.46 -2.82 11.00

Poland 12.63 -12.19 2.37 7.37

Russia 17.18 -15.35 2.76 19.63

Turkey 18.36 -5.94 5.14 9.70

Egypt 9.47 -12.51 3.55 20.28

Morocco 10.84 -3.99 15.70 10.63

South Africa 30.70 -6.36 10.11 14.52

S&P 500 15.06 -2.86 2.29 1.41

Through 12/31/2010. NA=Not Applicable. Sources: MSCI; Standard & Poor's

Latin American mining companies are also expected to excel this year, says Pangaro. In

Chile, he likes Antofagasta (ANTO.U.K.), a low-cost copper mine whose stock price

jumped 62% in 2010. The company is in a net cash position and is expected to increase

production over the next few years as it brings new projects on line, says Pangoro. Apart

from being a play on the MSCI Index for Chile, which was up more than 40% last year, the

company is also a play on inflation in, and the recovery of, commodities prices last year.

One vehicle that would benefit directly from the region's growth is the $1.1

billion BlackRock Latin America Fund (MDLTX), which was up 18.67% last year.

There are even country-specific ETFs for investors to bet on Brazilian interest rates should

they continue to rise, such as the $132 million WisdomTree Dreyfus Brazilian

Real Fund (BZF), which tracks money-market rates in Brazil and returned 12.62% in

2010. "In the short term, emerging markets may trade sideways," concludes Pangaro.

"Over all we remain constructive in Latin America."

A prominent theme among emerging-market stock funds this year will be a preference for

consumer staples like supermarket chains, which even the middle class can't live without,

over discretionary stocks like department stores, where consumers might avoid spending

money, says Irvine. P/E ratios on some emerging-market consumer-discretionary stocks

already are higher than those on their U.S. peers.

The growth-oriented Matthews Pacific Fund favors retail stocks, particularly in China,

where the economy grew at about 10% last year. The challenge is to find companies that

can raise prices in an inflationary environment without hurting sales. "To mitigate that

[inflationary] risk, we generally try to find companies that have pricing power and

companies that are focused on domestic demand," says Robert Horrocks, chief investment

officer of Matthews International Capital Management in San Francisco. One favorite

is Dairy Farm International Holdings(DFI.Singapore), which owns the 7-Eleven

convenience stores and other retail franchises in China and Southeast Asia.

A less expensive investment theme is the construction of highways, airports, train stations,

wireless networks and other infrastructure by publicly listed companieschosen by their

governments, particularly in China and India. Spending on such projects is expected to

rise regardless of inflationary pressure. "A lot of these companies are making investments

that will likely grow earnings substantially in the future," says Lazard's Donald, whose

fund is growth-oriented. Donald likes China State Construction International

Holdings (3311.Hong Kong), which soared 130% last year. Over all, the fund's holdings

are still a bargain, trading at a discount of 8% to the MSCI Emerging Markets Index.

Mark Mobius, executive chairman of the Templeton Emerging Markets Group, says he's

working with analysts in Templeton's private-equity arm for institutional investors to

identify cheap, small-cap stocks before they go public. He then buys the IPOs. "One of the

nice things about small caps is that we were able to find valuations much, much lower than

in large-caps, and that helped us a lot," he says. "When they go public they really explode."

He likes China High Speed Transmission Equipment Group (658.Hong Kong),

which makes gearboxes for use in windmills being built across mainland China. The

company is up 70% from the end of its first day of trading in July 2007.

In the small-cap universe, another strategy is pretty straightforward: Buy stocks not yet

covered by Wall Street, wait for them to get discovered, and then watch them jump. This

strategy has worked at $832 million Wasatch Emerging Markets Small Cap Fund

(WAEMX), which shot up 41.22% last year. The fund's holdings, which are trading at an

average of 13.2 times 2011 earnings, have a high return on capital and are able to finance

their own growth, says Laura Geritz, the fund's portfolio manager. Among those not yet on

Wall Street's radar, Geritz likes Sporton International (6146.Taiwan), a Taiwan-listed

conformance-testing lab for product safety in the consumer-electronics industry,

and Pacific Online (543.Hong Kong), an Internet-content site in China that she

estimates won't need much capital to fund growth.

Offering a lower-cost alternative to such actively managed funds, several firms offer small-

cap ETFs at much lower expense ratios. The WisdomTree Emerging Markets SmallCap

Dividend Fund (DGS), for example, returned about 30% with an expense ratio of just

0.63%, while theSPDR S&P Emerging Markets Small Cap ETF (EWX) delivered

23.50% at a 0.66% expense ratio.

While active managers at GEM funds try to maneuver around 2011's challenges, the long-

term case for emerging-market stock funds remains intact. As Morgan Stanley strategist

Garner says, "The higher growth should ultimately see us through, as will the higher

return on equity that emerging markets are delivering. Currencies are still undervalued,

particularly in Asia, which means currency gains for a dollar-based investor." He and

others suggest investors look for chances to boost their positions if there is turbulence.

"A lot of investors are realizing that they are severely underweight in emerging markets,"

says Mobius. "I think some lessons have been learned."

A Stellar Year for Emerging-Markets Funds

Top-performing funds focused on developing nations boasted returns as high as 45% in 2010. Gains

nearer 10% are likely in 2011.

Assets Expense Total Return*

Mutual Funds Ticker (mil) Ratio 1-Year 3-Years

5-Years

Wasatch Emerging Markets Small Cap

WAEMX $832 2.06% 41.22% 9.69% NA

T. Rowe Price Emerging Europe & Mediterranean

TREMX 770 1.64 33.48 -10.13 4.58%

Matthews India MINDX 1,400 1.27 32.53 -0.50 17.14

Templeton Emerging Markets Small Cap

468 2.10 30.30 1.84 NA

ING Russia LETRX 464 2.21 27.57 -5.80 12.84

Aberdeen Emerging Markets

GEGAX 206 1.77 27.44 -1.61 13.34

Oppenheimer Developing Markets

ODMAX 21,000 1.35 26.98 6.25 14.97

Matthews Pacific Tiger MAPTX 5,600 1.13 22.30 4.94 14.46

BlackRock Latin America

MDLTX 1,000 1.63 18.67 5.82 20.33

Oberweiss China Opportunities

OBCHX 292 2.07 17.43 -1.03 22.83

Exchange Traded Funds

iShares MSCI Chile Investable Market Index

ECH 984 0.65 45.77 19.38 NA

WisdomTree Emerging Markets SmallCap

DGS 915 0.63 28.91 8.26 NA

Dividend

iShares MSCI Mexico Investable Market Index

EWW 1,700 0.55 27.46 5.00 13.35

iShares MSCI Taiwan Index

EWT 3,300 0.82 21.13 4.69 7.99

Vanguard Emerging Markets Stock

VWO 43,300 0.27 18.97 -0.32 12.27

SPDR S&P Emerging Markets

GMM 232 0.59 18.13 0.95 NA

*Through 12/31/2010, 3-Year and 5-Year are annualized. NA=Not Applicable.

Source: Lipper

MICHAEL SHARI is a freelance journalist in New York who covers emerging markets,

finance and politics.