Emerging-markets-equity funds see big 1Q outflows

A cold front materialized in the first quarter for the once-hot emerging-markets-equity sector as U.S. investors pulled out $1.85 billion from the fund category. That represented about 11% of the $17 billion they invested last year, according to an estimate from Chicago-based Morningstar Inc. It was the first quarter of outflows for such funds in nearly two years, the research firm said. "In the first quarter, if you were an equity investor, where could you hide?" asked Jeff Tjornehoj, senior research analyst at New York-based Lipper Inc. "People are definitely more responsive to volatility in the market and very sensitive to perceived riskiness," he said. "I think what we are experiencing in the broad sense is, there is a crisis of confidence." Consequently, emerging-markets-equity funds weren't alone in seeing outflows during the first quarter.

'VOLATILE INVESTMENTS'

"Almost every category of equity had net redemptions," said Jeffrey Knight, managing director and chief investment officer of the global asset allocation team at Boston-based Putnam Investments. "The survival instinct is kicking in." The beneficiaries of the outflows were largely money market and bond funds, Lipper found. Performance was also off, with the emerging-markets-equity category slipping almost 12% in the first quarter, according to Lipper. "These are volatile investments," said Bill Rocco, senior fund analyst at Morningstar. Yet emerging-markets-equity funds have posted solid returns in the past, with a one-year return of 19.63%, a three-year return of 31.19%, a five-year return of 33.5% and a 10-year return of 11.99% as of April 22, according to Morningstar. And the year-to-date return of -4.61% as of April 22 indicates something of a comeback this month. The turnaround in emerging markets is in line with the turnaround of other equity markets globally in the past month, said Morningstar fund analyst Gregg Wolper. "Emerging markets are for investors with a long-term investment horizon," Mr. Rocco said. "Even then, you should pick a broad-based, diversified emerging-market fund and not bet on a particular region or country." Some financial advisers are indeed taking a step back. "We actually cut our exposure to emerging markets in half late in the third quarter of last year, said Joseph Alexopolous, co-founder and principal at Aequitas Wealth Management LLC of Los Angeles, which oversees $15 million in assets. "Emerging markets have had returns of 35% to 40% over the last five years," he said. "I don't feel that kind of growth is sustainable over the next five years. There's a lot of risk there." Returns from emerging-markets-equity funds became accentuated when domestic-equity markets experienced a downturn last year, said Kevin Reardon, president of Shakespeare Wealth Management Inc. of Brookfield, Wis., which has $50 million in assets under management. "We had to re-balance our ac-counts in 2007 because the international and emerging markets had grown beyond the asset allocation parameters," he said. "We like to keep it at 5%, with an upper limit of 8%." Mr. Reardon expects that the firm will scale that level back to 3% and maybe eliminate exposure to emerging markets in the next 12 to 18 months. I believe that everything in life reverts back to a mean. Emerging markets have exceeded that average dramatically for seven years," he said. "We are very cautious," Mr. Reardon said. "The correlation to our market is low, but now we are getting long in the tooth with their performance." Not all firms share that view. Balasa Dinverno & Foltz LLC just last week increased the equity exposure to emerging markets in its model portfolio to 5%, from 3%. The firm introduced emerging markets to its portfolio in 2006 with a 3% allocation and the intention of increasing that level, said Chuck Neff, wealth manager at the Itasca, Ill.-based firm, which manages $1.5 billion in assets. In the past two years, Balasa Dinverno increased its foreign exposure overall to 28%, from 20%. The firm considered the recent volatility but also wanted to get the emerging-markets weighting more in line with the proportion in the global market. Mr. Neff expects emerging markets' performance to bounce back. "It's not inconceivable that while the U.S. economy slows, that emerging markets still do well," he said. "We are not the only country they are exporting to." But some fund managers are wary. The 182 fund managers surveyed in a Merrill Lynch & Co. Inc. monthly survey released April 16 ex-pressed caution about emerging markets. In that survey, U.S. equity was the preferred sector for the first time since 2001. Sixty-seven percent of the respondents said they expected corporate profits in emerging markets to worsen in the next 12 months, ac-cording to New York-based Merrill. But one fund manager is optimistic. Patricia Ribeiro, portfolio manager for Kansas City, Mo.-based American Century Investments' $1.08 billion Emerging Markets Fund, thinks emerging markets can still deliver good returns. There are a lot of attractive in-vestment opportunities, including sectors such as infrastructure and oil services, and markets in Latin America, she said. When returns improve, the investors will move back in, said Howard Schneider, president of Practical Perspectives, an industry consulting firm based in Boxford, Mass. "There's still a herd mentality among many investors. When did many buy into emerging markets? After the returns already went up," Mr. Schneider said. "It's OK for a slice of your portfolio, but you need to look at the long-term horizon and be able to tolerate that risk," he said. Some equate the lure of emerging markets to the technology stock frenzy of a decade ago. "It feels the same as the late 1990s, when everyone was excited about telecommunications and the Internet, and thought that growth was unlimited," Mr. Alexopolous said. E-mail Sue Asci at sasci@investmentnews.com.