Advisers must answer for emerging-markets rout as U.S. stocks rally

Emerging markets were having their star turn in 2011 as financial advisers, retail investors and institutions poured tens of billions of dollars into stocks and bonds of countries such as Brazil, China, Korea and others, as Europe and the U.S. struggled mightily to emerge from their deep recessions. But even as those markets surged from all the cash flowing to them, advisers began to see signs that some were getting overvalued. Daniele Donahoe was one. “We started to pare back China, Brazil, a lot of these countries that did well because I thought valuations were extended and they developed a lot of momentum,” said Ms. Donahoe, president and chief investment officer of Rinehart Wealth Management. Things have clearly changed. Emerging markets have been seriously tested since last May, as a result of worries about Chinese economic growth and the effect of the Federal Reserve tapering its bond-buying program. Analysts say the program, known as quantitative easing, depressed yields and sent investors across borders searching for enhanced returns. So when the Fed began in January to cut back its multibillion-dollar bond-buying program, emerging markets tumbled as investors fled. The Fed is expected to trim its bond buying by $10 billion next month but may not end the program for many more months, leaving largely unresolved the question of how much that stimulus inflated emerging market assets. A research note released Thursday by Bank of America Merrill Lynch analysts said the taper will “almost definitely” impact emerging markets. “Both real policy rates as well as market yields in [emerging markets] had reached levels that could hardly be rationalized without a reference to very low real policy and market rates in the developed world,” they wrote. Facing both dropping currencies and stocks, investors pulled nearly $9 billion from emerging- markets mutual funds and ETFs last month, according to Morningstar Inc. But some investors have been rewarded. Ms. Donahoe, for instance, recommended her clients ditch an index-tracking exchange-traded fund, the Vanguard FTSE Emerging Markets Fund (VWO), but maintain exposure through actively managed funds to navigate to values in other emerging and even frontier countries. The index tracker is down nearly 8% over the last year through Feb. 27. But investors who loaded up, one year ago, on an alternative employed by Ms. Donahoe, Wasatch Frontier Emerging Small Countries Fund (WAFMX), have enjoyed returns of 11%. It's more than stomach-churning volatility — always a hallmark of emerging markets — that's coming into play. Investors are seeing widely disparate outcomes based on the countries and securities they — or their fund managers — choose. In theory, an investor who had taken Ms. Donahoe's advice and put money into the Wasatch Frontier Emerging Small Countries Fund a year ago would be sitting pretty. Another who purchased the Wasatch Emerging Markets Small Cap Fund (WAEMX) would be sitting on a decline of more than 10% over the same time period. Last month, Michael Swell, the co-head of global portfolio management for Goldman Sachs Asset Management, said that the fate of emerging markets could diverge, depending on their exposure to two waning forces: Fed liquidity and the Chinese economy. Emerging markets with more exposure to China and commodities could do far worse than those that are not, according to a copy of a presentation Mr. Swell delivered last month at a New York conference of the Investment Management Consultants Association. Despite the head winds, he and other analysts agree that emerging markets are broadly attractive, but the difference between countries is making security selection — bonds less exposed to exchange-rate risk, stocks with low valuations and growth prospects —more important. That's a distinction that some advisers say might favor active, not passive, fund management. But advisers still have to explain their exposures to those markets to investors, who saw the domestic-blue-chip-tracking S&P 500 gain 29.6% last year. The MSCI Emerging Markets index, by contrast, declined 2.6%. “People don't want to make mistakes and say something looks good and then it gets into trouble,” said Timothy F. McCarthy, a former asset manager and Charles Schwab & Co. president who wrote “The Safe Investor” Palgrave MacMillan, 2014). He said that, along with a limited product set, causes people to overlook opportunities in emerging and frontier markets. “I understand the challenge to the press and the adviser — you've got to say what people want to hear.” “They look at their returns and they see the S&P is up 30%,” Gary Brooks of Brooks Hughes & Jones Inc. said of clients. “The thumb has been hit with the hammer there, and you've got to address it.” Advisers do have history on their side. Over the past 10- and 15-year periods, no broad market stock or bond category has done better on an annualized basis than the emerging markets. And while emerging markets as a broad category was down 3.3% last year, the category also averaged 12.1% over the past 10 years and 13.3% over the past 15 years. Mr. Brooks' more aggressive clients have about 12% exposure to emerging-markets stocks and debt. “They come with more volatility — that's just a piece of the story,” he said. “If there's a reasonable expectation to be compensated for the risk you're taking, go ahead.” But what's reasonable is what's in question. Mr. Brooks and others, such as UBS adviser Maurice G. Bradshaw, see emerging-markets exposure, even with the risks presented by currency slides, capital flight and slowing growth, as essential, given the growing middle class in many of those countries. And there is some evidence of a rebound as emerging-markets stocks have rallied this month. Others, like Jeffrey Sica, president and chief investment officer of SICA Wealth Management, are more bearish. He said any economic slowdown in the second-largest economy is felt across the world, and political problems from Brazil to South Africa could cripple them. “We've seen this bloodbath in currency — and the only thing that's really going to stop that is for this currency war, this devaluation in China and the U.S. and Japan to subside,” said Mr. Sica. He is recommending gold, other precious metals and commodities like oil for his clients, taking physical delivery of the metals when possible. “Precious metals are used as a protest against the governments that print currency,” he said, “so when you see instability in the markets and riots in Ukraine and the economic problems in Turkey and Brazil, the safe haven gold investment becomes much more attractive. So we've stocked up.”