How to Play Red-Hot Emerging Markets

 | Mar 07, 2012 | 11:00 AM EST
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Emerging markets don't get a lot of play in the U.S. financial media. But that hasn't kept U.S. investors from piling into this red-hot asset class in 2012.

Barron's just reported a set of figures that is almost too extreme to believe, even for a global bull like me. Investment management firm BlackRock (BLK) recently reported that $7.9 billion of the $9 billion that investors invested into equity exchange-traded funds around the world during February headed into emerging-markets ETFs. That's a whopping $8.77 out of every new $10 invested. That's the strongest start ever in terms of asset gathering for emerging markets.

In the U.S., almost all this money has gone into the Vanguard MSCI Emerging Markets ETF (VWO) and the iShares MSCI Emerging Markets Index Fund (EEM), both of which are near the top of the list in terms of asset growth for U.S. ETFs.

Early investors have been rewarded so far. Despite a sharp 3.3% selloff Tuesday, emerging-market ETFs are up 11.75% for the year. Some have done even better. The BRIC markets -- Brazil, Russia, India and China -- have all outperformed the MSCI Emerging Market Index this year. The Russian market leads the way with a 17% gain in Market Vectors TR Russia ETF (RSX).

But as any old hand will tell you, emerging markets are either feast or famine. As impressive as short-term gains can be, they can disappear virtually overnight. That's what makes the asset class so hard to hold on to.

That said, if you can stick with emerging markets in the face of gut-wrenching volatility, it's hard to go wrong. Over the past 10 years, emerging markets have returned roughly 15% per annum -- trouncing the S&P 500's anemic low single-digit rise.

That's why I have a constant 12% weighting in emerging markets for my clients, through thick and thin.

But I also have a strategy whereby I tweak these returns even more.

I do that by investing 8% of my clients' assets in VWO because the management fees are cheaper than for EEM, and 4% in an emerging markets small-cap index through the SPDR S&P Emerging Markets Small Cap ETF (EWX). That's the way I capture the small-cap effect in emerging markets.

As the former manager of a top-performing emerging-market fund, I can tell you that you'd be very hard pressed to find any active emerging-markets fund manager who could outperform this asset allocation over the long term.

Stick to this strategy and you'll be amply rewarded.

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