What you’re missing

If you’re still avoiding emerging markets, it’s time to rethink your position. Yes, these markets can be volatile, but if you want to benefit from the growth of the global economy, you can’t avoid up-and-coming countries.

One good reason to pay attention to these upstart economies is their sheer size. The four biggest of the emerging nations are Brazil, Russia, India and China, which are often referred to collectively as the BRIC countries. Just like a true brick, the BRIC countries pack a wallop. China and India are the world’s two most populous nations; Russia and Brazil also rank in the top 10, with populations many times that of Canada.

The BRIC countries are just the beginning of what’s available outside the developed world. The emerging markets category ranges from Poland to South Korea to Mexico to South Africa. Taken together, emerging markets now represent about a quarter of the global economy. Since 2001, their economic growth rate has been triple the growth rate of developed economies. Stock markets in these emerging market economies have churned out 21%-a-year gains over the past three years.

Strangely, though, Canadians don’t seem much impressed by this sizzling growth. Emerging market equities represent less than 1% of the money held in Canadian mutual funds. I fear that Canadians are simply not recognizing the new realities of the marketplace.

The most common objection I hear to investing in emerging markets is that these markets are too volatile. To some degree, I can sympathize with the complaint. Last summer, emerging market equities lost 25% of their value in less than two months. They subsequently regained all their losses, but their temporary plunge was scary.

The unfortunate reality is that you can expect more of the same. Emerging markets involve risk. Brazil and Mexico suffer from social imbalances and inefficient tax systems. Russia is moving back towards autocracy. India has to deal with inflation and a growing current account deficit. China is still a communist country where the rule of law is unpredictable.

But the problems don’t outweigh the potential. The key to investing in emerging markets is protecting yourself so you enjoy a high chance of profit and a low chance of losing your shirt. Here are four tips to help you on your way:

Think about the big picture

It’s reasonable to dedicate 15% to 20% of your portfolio to emerging markets. Don’t invest more unless you are a gambler.

No matter how much or how little you invest, make sure you diversify your holdings to ensure that a downturn in one region or country can’t sink your portfolio. In particular, you should avoid mutual funds that specialize in a single emerging market country or a small region. The risk is simply too high. A well-diversified emerging markets portfolio would have the bulk of its assets in the Asia-Pacific region (outside of Japan) with smaller portions invested in Latin America, Eastern Europe and Russia, and South Africa.

To hedge your bets, look at what else is in your portfolio. Emerging market funds usually move in ways that are out of step with Japanese equities, Canadian financial services or even Canadian balanced funds. If you mix your emerging markets investments with one or two funds from those other categories, you reduce your overall risk, since any downturn in one area is likely to be counterbalanced by gains in the other.

Go global

Choosing your own emerging market mutual fund can be tricky, since the funds available in Canada tend to be expensive and often go on hot or cold streaks that have little to do with management skill. As an alternative, consider investing in a global equity fund that has an emerging market component. The Trimark Global Endeavour Fund, the Chou Asia Fund and the Mawer World Investment Fund are all good examples.

Cut costs

If you decide to go all the way with a pure emerging equity fund, buy an exchange-traded fund (ETF) such as the MSCI Emerging Markets Index Fund, which trades on the American Stock Exchange (AMEX: EEM). This ETF gives you instant exposure to emerging markets around the world at much lower cost than an equivalent mutual fund.

It’s not just stocks

Consider emerging market bonds. A diversified portfolio of emerging market bonds is now yielding 2.5 percentage points more than a portfolio of Canadian bonds (or two percentage points more than U.S. bonds). With Canadian 10-year bonds currently offering a paltry 4% yield, this extra return is a welcome bonus for income-hungry investors.

The additional return isn’t without risk, of course. As Argentina demonstrated two years ago, governments in emerging countries sometimes default on their bonds. Still, if you keep a diversified mix of bonds, the risk premium should more than compensate you for any losses caused by default.

Before investing, you should be aware of a couple of specific pitfalls. The first is currency risk. You may take a hit if the currency the bond is issued in loses value against the Canadian dollar. This is true of any foreign investment and the best defence is a well-diversified portfolio that is split up among many different currencies.

You should also be aware that emerging market bonds fluctuate depending on how investors perceive their relative risk. The current two percentage point spread between emerging market bonds and U.S. government bonds is low by historical standards, suggesting to some observers that emerging market bonds are overvalued. Remember, though, that these are bonds, not stocks. If you (or your portfolio manager) hold on to your investment, you can enjoy the extra yield from these bonds and get back your principal upon maturity. The key is to invest only money that you will not need in the next few years.

To find a good emerging market bond fund, you will have to go outside of Canada and look at some of the ETFs available on the U.S. stock exchanges. You can examine the selection at a website called ETFconnect.com. Look for emerging market funds under the “Fixed Income” category. The site shows you the current annual interest payments and the degree of risk the fund is taking on. Risk is measured by the average credit rating of the portfolio. The holdings of emerging market bond funds typically range from relatively low risk BB+ bonds (one notch lower than investment grade) to high-risk C issues. You should look for a mix of high yield with relatively low risk. Right now, I think the Western Asset Emerging Markets Income Fund II, Inc. (NYSE: EDF) is appealing. It offers an 8% current income distribution level and has a BB+ average portfolio rating.