These aren't marginal investments. While retail investors may hold little in regional funds, such as a Latin American equity fund, many do have exposure to broad emerging markets funds. These funds in turn have significant weightings in countries beyond China and the Asia region, including Latin America, Eastern Europe and South Africa, all heavily dependent on commodities for exports—namely, oil and gold.
Many 401(k) plans now have a discrete emerging markets fund as an option, too, as having exposure to the developing world has been a big marketing push for the fund industry in the past decade. The Vanguard Emerging Markets Stock Index Fund (VEIEX), for example, has $61 billion in assets—representing almost all of the assets in emerging markets index funds, which at the end of 2014 stood at $63.5 billion, according to Morningstar data.
From 2010 to 2014, assets in diversified emerging markets funds, both passive and active, grew from $226 billion to $303 billion, according to Morningstar, with the greatest growth occurring in 2012 and 2013, at 30 percent and 14 percent, respectively. By 2014 the growth rate in assets slowed to a crawl, at just over 3 percent, but according to Vanguard, 29 percent of the retirement plans it services now offer a distinct emerging markets fund.
Net asset flows in emerging markets funds
Actively managed diversified EM funds: $10 billion
Index diversified EM funds: $3.9 billion
India funds: $475 million
China funds: ($360 million)
Performance of emerging markets funds
Actively managed diversified EM funds: (14.23 percent)
Index diversified EM funds: (14.42 percent)
(Source: Morningstar, data as of 9/09. Parentheses indicates negative flows and performance.)
The data on correlations doesn't imply an investor should throw in the towel on diversification, but maybe that they should throw out some of the assumptions that have led to a lazy or, in the least, too broad an approach to investing in emerging markets. For one, if you're worried about whether you should stick with an emerging markets fund, you can't just look to China for answers. Look at how much it costs to fill up your gas tank.
Unfortunately, the commodity downturn probably won't end until China recovers, because it is the world's largest commodity consumer. "Growth is decelerating in emerging markets, particularly for China, so the demand for oil and natural resources seems to be slowing," said Michael Arone, an investment strategist at State Street Global Advisors. "That leads us to underweight both emerging market stocks and commodities."
Many emerging markets were suffering long before China's stock bubble popped this June. Major components of most emerging markets funds—Brazil, Russia, South Africa, Chile and Indonesia—are heavily dependent on commodity exports to grow. Their markets have been tanking for several months because of the collapse in oil, gold and other resources.
As a result, while the average commodity mutual fund is down 30 percent in the past 12 months, the average emerging markets fund has also fallen 25 percent, according to Morningstar.
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Because of the increased correlation, Haworth, who has discretion to advise investments in both active and passive strategies across all asset classes, has been recommending his clients keep a lower than average weighting in commodities in their portfolios. Meanwhile, despite their cheaper valuations than U.S. stocks, he is only neutral on emerging markets. What's more, he thinks clients should now be using actively managed emerging funds instead of index ones.
"We're seeing a much greater differentiation in the emerging markets story than we had prior to this time," Haworth said. "Before, there was a single narrative about investment-driven growth. But as the commodities tide has washed out, the stories in emerging markets have become different. Country selection in emerging markets funds begins to matter."
That's because while countries like Brazil export oil and other resources, countries like India and Turkey import them. Import countries should actually benefit from the commodity decline. So money managers who can underweight export countries and overweight import ones have an advantage over index funds that must hold a market-sized position in each country.
Top 5 actively managed emerging markets funds
Brown Advisory Emerging Markets Small-Cap (BAFNX): 3.9 percent
JOHCM Emerging Markets Small Mid Cap Equity (JOMMX): (3.1 percent)
Seafarer Overseas Growth and Income (SIGIX): (3.9 percent)
Huntington Global Select Markets (HGSIX): (3.9 percent)
ICON Emerging Markets (ICARX): (5.3 percent)
(Source: Morningstar, data as of 9/09. Parentheses indicates negative performance.)