Emerging markets funds up, but rely on developed world

Money has been pouring into emerging markets funds, but experts say they could be heading for a fall.

Emerging stock markets — those that are in relatively young, small or developing nations — have been on a tear this month. The MSCI emerging markets index gained 12.4% through Tuesday, vs. 7.6% for MSCI's U.S. stock index.

Some emerging markets have been soaring:

•India, up 15.7% this month.

•Brazil, 15.5%.

•Russia, 20.2%.

As emerging markets have surged, money has poured into the funds that invest in them.

This year, investors have put $5.5 billion of net new money into emerging market stock funds, says Brad Durham, managing director of Emerging Portfolio Fund Research, which tracks the funds.

To put that into perspective, the funds have attracted new money equal to about 2% of their assets each week for the past month, according to TrimTabs.com, which also tracks fund flows. In contrast, diversified U.S. stock funds have seen outflows equal to about 2.4% of their assets over the same period.

Hot performance tends to drive fund flows, because investors love to put money into a fund with big gains. But big torrents of new money going into smaller markets can propel them even higher.

Are investors setting themselves up for big losses — such as they experienced last year, when the average diversified emerging markets fund plunged 54%, vs. a 37% loss for the Standard & Poor's 500-stock index?

Quite possibly, says Alec Young, equity market strategist for S&P. "Bounces off the bottom can be misleading," Young says.

When the developed world's economies recover, emerging markets should soar, because those countries typically have higher economic growth rates than the U.S., Europe and Japan.

He's not convinced that the developed markets have recovered yet — and that means tough times ahead for emerging markets if he's right. "The easy money has been made," Young says. "We'd be sellers here."

And much of the money that's been made has come from exchange-traded funds, where money can move in and out extremely quickly. EPFR Global estimates that $4.5 billion of the $5.5 billion that has flowed into emerging markets funds has been in emerging markets ETFs.

Longer-term investors might consider investing now, assuming they have the stomach for lots of short-term volatility. One reason: People in emerging markets aren't as much in debt as their counterparts in developed nations, says Todd Henry, emerging markets equity portfolio specialist for T. Rowe Price. "Credit is a new phenomenon there," he says.