Column - How to deal with emerging markets volatility

CHICAGO Mon Feb 10, 2014 11:16pm IST

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CHICAGO (Reuters) - Since the beginning of the year, emerging markets have been like cats on a hot tin roof.

Hot money is skittering out of foreign markets as countries from Argentina to Turkey have been clawed by economic and political turmoil. But even with heightened concerns about the prospects of developing countries, emerging markets should still be a part of your larger portfolio.

A combination of currency crises and the "taper" of the Federal Reserve's bond-buying program - possibly resulting in economic slowdowns - have triggered the exodus in emerging markets. More than $12 billion left emerging markets stock funds in January alone, according to EPFR Global, with bond funds in this sector losing nearly $3 billion last week alone.

While nearly every emerging markets fund has been nicked this year, some funds have been clobbered. The WisdomTree Brazil Real ETF (BZF.P) lost 90 percent of its assets between January 28 and 29.

A common strategy is to invest in countries that are not part of this rout. That means pulling money out of countries like Argentina, Brazil, Indonesia, Turkey and South Africa and moving into countries whose currencies are more stable. While that's easy for institutional investors or those holding country-specific exchange-traded funds (ETFs), it's awfully difficult for individual investors.

One consideration is to find a wider base of smaller, "frontier" countries that are not being impacted by the currency woes or the Fed's moves.

The iShares MSCI Frontier 100 ETF (FM.P), for example, has 81 percent of its portfolio in Africa and the Middle East, with only 13 percent in Asian emerging markets and 4 percent in Latin America. It's up 1.4 percent year to date through February 7 and gained almost 24 percent last year. It charges 0.79 percent in annual expenses.

HOW TO VIEW THE VOLATILITY

If you want to isolate trouble spots, you'll have to prune your portfolio to avoid trouble ahead.

The "Fragile Five" - India, Indonesia, Brazil, Turkey and South Africa - are vulnerable because of a plethora of economic and political problems. According to Neena Mishra, director of ETF Research for Zacks Investments in Chicago, you may need to do some incisive sorting.

Mishra says the most troubled countries have high current account deficits to GDP and short-term external debt to foreign exchange reserves ratios - "that is, countries that are dependent on foreign capital and are thus vulnerable to the Fed's taper."

But not all emerging markets are alike. Some have healthy economic outlooks and are worth holding. Mishra likes countries prone to "solid macroeconomic fundamentals, pegged currencies (to the U.S. dollar) and low correlations to developed markets." This group would include the Gulf states, Mexico, South Korea, Taiwan and Vietnam.

While it's tempting to cherry pick developing countries, is it practical to strip out the most troubled countries from your portfolio? Probably not, which means a general emerging market index fund might be too volatile right now - if that's a short-term concern.

A global fund that invests in both developed and emerging markets might fit the bill. The Vanguard Total World Stock Index ETF (VT.P), invests in a mix of mostly large companies with only about 8 percent of its portfolio in developing countries in Africa, Asia and Latin America.

Although it's down 3 percent year to date through February 7, the Vanguard fund gained 23 percent last year and costs 0.19 percent in annual expenses. It holds well-known companies that have a global presence such as Apple Inc (AAPL.O), Nestle SA (NESN.VX) and HSBC Holdings (HSBA.L).

Another way of dealing with the uncertainty of emerging markets is to embrace it as the cost of doing business as a long-term investor. Don't bulk up in any one country or region and invest across every continent - if you can afford to take the risk now.

What you will not be able to do with any global or emerging markets fund is to avoid ramped-up volatility this year. To dampen that concern, reduce your foreign exposure to no more than 20 percent of your portfolio or simply stomach the risk and hold for the long term.

For more from John Wasik see link.reuters.com/syk97s

(Editing by Lauren Young and Stephen Powell)

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