BARRON'S COVER
Wish You Were Here
By TOM SULLIVAN
After getting comfortable overseas, U.S. investors may find it tough to come back.
FACED WITH A SHAKY U.S. ECONOMY AND a weak dollar, Americans poured a record $64 billion into foreign-mutual funds last year. A little more than half of that amount flowed to emerging-market equity funds, with the remainder going to foreign-bond funds. The money flows are expected to continue this year, especially into emerging markets.
"In 2010, investor appetite [for emerging markets funds] will be higher because emerging markets performed better [in 2008 and 2009] than in past crises," says Brent Jones, portfolio manager at GE Asset Management, with $116 billion in assets as of Sept. 30. Citing International Monetary Fund data, Jones notes that two-thirds of the expected growth in the world's gross domestic product this year will come from emerging markets.
Little wonder U.S.-based emerging-market funds attracted inflows of $34 billion in 2009, according to EPFR Global, which tracks flows worldwide. Developed bond-market funds also were a magnet for U.S. money, drawing in nearly $28 billion on top of the $2.7 billion the emerging-debt markets received. In contrast, more than $40 billion flowed out of U.S. equity funds.
Whereas the developed-market bonds may have gotten an exaggerated boost from U.S. investors' desperate search for yield and safety last year, the emerging-markets equity tilt appears more permanent. "People pay for growth," Jones says. And despite 2009's phenomenal emerging-markets stock rally, valuations are "not outrageously expensive," he adds.
The average price/earnings multiple for emerging markets stocks is 13.5 times 2010 estimates, compared with 15 for the Standard & Poor's 500. Alec Young, international equity strategist at Standard & Poor's Equity Research, notes that the gap in valuations persists even though the IMF recently predicted 5% economic growth for emerging markets and just 2% to 3% growth for developed economies in 2010.
THE OUTFLOW MIGHT SLOW IF Federal Reserve Chairman Ben Bernanke chooses to defend the dollar by raising U.S. interest rates, even slightly. Likewise, any sign the Obama administration is serious about deficit reduction would probably brighten prospects for economic growth and keep more investment dollars on U.S. shores. In December, for instance, with the dollar rallying at last, $14 billion on balance came rolling into U.S.-focused equity funds, a sign of how quickly sentiment can change.
That said, there is little likelihood that Americans' foreign investment adventure is going to end any time soon. "After a dead decade" in U.S. equities, when the S&P 500 index finished with a negative total return for the first time ever, emerging markets offer "the only place to possibly outperform," says Richard Kang, chief investment officer at Emerging Global Advisors, which has launched the first non-U.S.-dollar-denominated metals and mining exchange-traded fund, or ETF, the EGS DJ Emerging Markets Metals and Mining Titans (EMT).
The nascent markets' appeal to American money didn't extend to developed foreign-market equities, which saw withdrawals of about $600 million last year, according to EPFR.
Not only are emerging markets faster- growing and cheaper than developed counterparts, but their success begets success. There are now 514 emerging-market stock funds and 103 emerging bond funds in the U.S., compared with 327 and 59, respectively, five years ago.
What's more, as these markets expand, they play a bigger role in various global indexes, drawing in still more money from these passive investment vehicles. For instance, the emerging-markets portion of the MSCI All-Country World Index's capitalization is 13%, up from 5% five years ago.
As David Kotok, chief investment officer of Cumberland Advisors, points out, the U.S. used to have 50% of the world's equity capitalization but, since March of last year, it has had about a third. By comparison, China, including Hong Kong, has gone from a world market weighting of 1% in 1998 to about 12% today, says Kotok, whose firm is based in Vineland, N.J., and Sarasota, Fla.
That shift has forced investors to reallocate their global assets and align them more closely with economies that are on the rise, possibly for decades to come.
ACKNOWLEDGING THAT SOME OF these changes are simply portfolio managers or individual investors "chasing performance" or pursuing "momentum" strategies, Avi Nachmany, director of research at consultant Strategic Insight, says "secular allocation" to emerging markets is growing as well. The year "2010 won't reverse that theme," he says, adding that the 3%-to-4% allocations for emerging markets in many diversified funds are misguided, because the sector is no longer a "niche."
The average U.S. institutional portfolio has about 70% of its money in U.S.-centered funds and 30% in international funds, about double the 15% of seven to eight years ago, says Nachmany. In recent years he has urged portfolio managers to consider a 50/50 U.S./foreign split. But now Nachmany suggests having a third in U.S. assets, a third in overseas developed nations and a third in emerging markets. He wouldn't take the plunge all at once, he says, but would use strategies such as dollar-cost averaging, in which equal dollar amounts are invested at regular intervals over time.
Of course, the dollar's decline has spurred interest in all overseas markets, including emerging and developed market bonds. The worldwide credit panic early late in 2008 and early in 2009 sent so many investors rushing into U.S. Treasuries that yields actually turned negative at one point.
Shortly thereafter, debt-fund holders began searching both at home and abroad for better yields. As a result, there was a surge of money into investment-grade-rated foreign sovereign and corporate funds. Meanwhile, emerging-market bond yields were so high that opportunistic investors couldn't resist and jumped in -- getting bargains of a lifetime.
Although that situation is unlikely to reoccur this year, there are other reasons to hold onto foreign funds. "The money going into emerging markets reflects the desire for dollar diversification, which is a permanent shift," says Lewis Kaufman, who manages the Thornburg Developing World Fund (THDAX), launched last month. Parent Thornburg Investment Management has total assets of $53 billion.
Given the huge U.S. deficits and its recent, surprisingly strong gains, the dollar would seem to be vulnerable to further declines as 2010 progresses. While no central bank has any interest in dumping its U.S.-dollar holdings, many continue to look for opportunities to diversify; some foreign leaders have even spoken of creating an alternative world currency to the dollar. As a result, it makes sense for investors to stay up with the trend by keeping more of their money abroad.
It isn't just worries about the dollar, however. The fiscal crisis in Greece has raised questions about the euro, Kaufman notes, while the Japanese yen has remained persistently strong.
That makes currencies in emerging markets like Brazil, which has strong capital flows and much-in-demand commodity exports, and China, which will decouple from the dollar eventually, worth a look, says Kaufman.
"In Brazil, the economic outlook has never been brighter," he says. And China, after using bank lending to build a dynamic export-oriented economy, is set to move to the next stage -- domestic consumption.
OF COURSE, THERE ARE RISKS. Emerging markets are notoriously volatile and not nearly as liquid as U.S. stocks or bonds. And there are some signs of bubbles. In China, for example, the real-estate market looks extremely pricey, after the government pressured banks to lend money and keep the economy chugging along while its export markets wilted.
China last week unexpectedly raised a key interest rate in the interbank market for the first time in five months, signaling its concern about inflation.
Even before that, HSBC analysts put out a report saying they are worried about the interest-rate outlook. "Rates look set to stay lower for longer in many developed markets, but the same cannot be said for the emerging world where the threat of rising rates is a clear and present danger and perhaps a necessity to combat overheating," the analysts wrote. They cited India, Korea and Indonesia as being most at risk from rising rates in the first half of the year.
HSBC analysts said they were closing their overweight position on the emerging world and, "by default," also their underweight position on the developed world. HSBC said it is "concerned that the 'long emerging markets' trade is a very crowded one."
Anything the Obama administration can do to spur a stronger-than-expected U.S. economic recovery would certainly nudge U.S. investors back to their home turf. Among the initiatives that might help -- even if only to slow the outflow from U.S. mutual funds -- would be "lowering the corporate income-tax rates, which would boost after-tax returns for U.S. equity, improving its attractiveness and helping keep investable funds at home," says John Lonski, chief economist at Moody's Investors Service.
If the administration can't do much, mutual and exchange-traded fund investors will demand higher returns and, in the U.S., "the cost of capital will be higher than otherwise, interest rates will be higher than otherwise, and P/Es will be lower than otherwise," says Lonski.
The Bottom Line
Mutual-fund money is likely to continue to flow abroad in 2010 and beyond to reflect the rapid growth and bright prospects for emerging markets.
Even without bold policy changes, U.S. equity funds can do a bit better at holding onto money in 2010 by extending 2009's rally, says Kotok of Cumberland Advisors. The S&P 500 hasn't yet hit its pre-Lehman Brothers-failure levels. Achieving the 1250 to 1300 level is "very doable," he says. The S&P closed Friday at 1,144.98.
"People are traumatized. But one at a time, they'll come back as the market will get more enticing," says Kotok. "The market will come back and come back robustly." A stronger outlook would certainly help keep fund money closer to home.
Despite the dollar's recent rebound, heavy government spending is likely to drag the greenback lower over the next few years. If so, expect Americans to keep putting their money into foreign mutual funds, and at a rapid clip.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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