Emerging markets: Hot performance worth the risk?

ByABC News
March 22, 2012, 8:40 PM

— -- Not too long ago, you could buy a can of compressed air that fit neatly over the opening of a clogged drain. When you pressed down, a huge blast of air would clear your drain. The clog, presumably, shot out of some startled homeowner's sink in Hackensack.

Torrents of money can also get markets moving — and quickly, too. And that's one reason why emerging markets are doing so well this year. But there are some long-term trends in emerging markets that argue for having them in your portfolio, too.

Emerging markets are stock markets in countries whose economies aren't big enough to be lumped in with powerhouses such as the U.S., but they also have plenty of room to grow. We're talking about countries such as Thailand, Brazil, China, Russia and India.

These markets tend to be small. For example, the Colombian stock market has a market value of about $200 billion, about $50 billion smaller than the largest U.S. mutual fund, Pimco Total Return.

While emerging markets are small, the global need for investment performance is high, especially with short-term interest rates so low. Global investors have poured $13.6 billion into emerging markets funds the last three months, says Lipper, which tracks fund flows. Not surprisingly, many emerging markets have soared this year, according to Bloomberg Business News:

•Colombia, up 27.2%.

•Turkey, up 25.5%.

•Thailand, up 19.7%.

But there's more to emerging markets than new money blasting in from abroad. Last year, inflation was rising in many emerging markets, and governments worked to slow their economies down. They succeeded, but at the cost of stock prices: The average emerging markets fund lost 19.9% in 2011, Morningstar says.

"Emerging markets overheated in 2010 because of excess growth in money and credit," says Justin Leverenz, portfolio manager of Oppenheimer Developing Markets. The poor in particular are hurt by rising inflation, especially rising food prices, he says. Now that inflation has been beaten back, Leverenz says, governments are cutting interest rates and encouraging growth again.

But the main reason to invest in emerging markets over the long term is that in many emerging markets countries, more people are moving into the middle class, meaning they have more money to spend on consumer goods, such as toothpaste. Colgate of India, for example, says toothpaste sales grew 13% in 2011, despite the difficult economic conditions.

One caveat to the emerging markets story: "With oil prices rallying higher than anticipated, it could throw a spanner (a wrench) in the works," says Devan Kaloo, manager of Aberdeen Emerging Markets. Gasoline and oil are often subsidized in emerging markets, shifting the problems from consumer finances to government finances.