Dealing With an Emerging Markets Overdose

Emerging markets like India and China continue to be a favorite destination for global investors in 2010.

The attraction is clear: fast-growing economies, with booming stock markets. Its not just large hedge funds investing here; average Joe's in the developed world are putting part of their retirement savings in emerging markets to diversify their investments too.

But what should residents of emerging markets do?

By virtue of living in India or China, you could be overexposed to emerging markets. If there's a serious downturn in the economy of your home country, it could hurt everything from your job to your local stock investments.

We saw that in the late 1990s, during the Asian crisis, when a collapse in the Thai baht spooked global investors and led to sharp declines in several Asian currencies, economies and stock markets, including those of South Korea and Hong Kong, while India's benchmark Sensex fell 25% in one year following the August 1997 crash.

Sure, Asian economies are much healthier now, and the U.S. and European economies are sluggish. But emerging markets can change quickly.

As a financial adviser once explained to me: It's because we don't know, that we diversify.

Stock returns in developed countries like the U.S. can appear meager in comparison to those in emerging markets. "When returns in any particular asset are high...people just stop thinking of diversification," notes Raghavendra Rau, a visiting professor of finance at the University of California at Berkeley.

Investors living in emerging markets such as India shouldn't even consider foreign investments until they have first fully diversified their investments within their home country, by buying diversified stock funds, and bond funds or through bank deposits which are the relatively safe part of a balanced portfolio.

But developed market stocks can provide a measure of stability to your portfolio as they lose less than emerging markets during downturns. "It is important to not conclude that stock returns are higher correlated to a country's future economic growth rate," says Brent Brodeski, a U.S.-based financial adviser.

[MAXMONEY] Reuters

A construction site in Chennai, India. A number of companies in India have launched mutual funds.

Also, ignoring developed markets means turning your back on 85% of the world's stock market capitalization, and multinational U.S. and European companies will benefit due to their businesses in different countries, even if their home counties are growing slowly.

The good news is that there are several ways for individuals in emerging markets to invest outside their home country -- investors in India can now park as much as $200,000 per financial year outside the country.

A number of companies in India and China have launched mutual funds in recent years, which invest in stocks listed abroad and a few brokerage firms in India allow individuals to invest directly in stocks and exchange-traded funds listed in some foreign markets.

The bad news is that it can be complex. Many of the mutual fund options available often don't provide ideal broad-market exposure, and they can be costly. Also, foreign investing involves currency risk, and with the Indian rupee getting stronger, for instance, it could lower your returns earned in foreign countries.

In mainland China, investors can choose from around 10 foreign mutual funds offered by qualified domestic institutional investors. But it is worth noting that four of these funds invest in Hong Kong where the market is highly correlated to Chinese stocks and thus the funds don't provide ideal diversification, says Y.T. Kum, senior research analyst at Morningstar Asia, based in Hong Kong. Mr. Kum suggests looking at funds which own global equities, or foreign bonds.

Also, while stocks in other emerging markets like Brazil are riding the high-growth wave like those in India and China, these markets are influenced heavily by foreign flows and a sharp increase in outflows, such as happened in 2008, can cause all these markets to fall suddenly and simultaneously. "The correlation between emerging market countries is very high, and secondly within Asia, the correlation is even higher," says Mr. Kum of Morningstar.

There are less than two dozen mutual funds in India which make some investments in foreign stocks, but most of them don't provide broad-based diversification. A majority of these global funds focus only on commodity-related companies, or real-estate stocks globally, so they are suited only for making bets on specific sectors.

Some funds, like the Principal Global Opportunities fund and Fidelity International Opportunities fund, invest primarily in other emerging markets and don't include developed market stocks.

The Fidelity fund puts only a third of its money into foreign stocks in order to be taxed like an Indian mutual fund. Long term capital gains on Indian stocks and mutual funds is tax-free, but gains on stocks abroad is subject to a 20% tax.

All these factors, combined with high costs for these funds and their limited investment track record make them tough to recommend, says Dhirendra Kumar, chief executive of research firm Value Research India Pvt. Ltd. Indian investors should put only 5% to 10% of your portfolio outside India, says Anik Shah, senior wealth manager at Anagram Capital Ltd.

Individuals who can spare time could buy stocks directly in the U.S. and some other stock exchanges, via brokerage firms like ICICIDirect.com and Kotak Securities. Pay attention to costs. At ICICIDirect, which provides access to only U.S. stocks, it costs 1000 rupees to open a new account, around 1200 rupees for remitting Indian rupees to the U.S. dollar, and the brokerage fee is 0.75% or $9, whichever is higher.

It's true that so far, foreign investing hasn't been popular in India, but I can imagine it will be a bigger part of our portfolios 10 years from now.

Write to Shefali Anand at shefali.anand@wsj.com

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