(PUB) Investing 2016

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April 201 6

Morningstar FundInvestor

The aim is similar to that of the geographically flexible funds: to give investors access to the potentially greater gains available from emerging markets while reducing the volatility inherent in an all- stock approach. The theory had numbers behind it. In the years just before many of these funds came out—five of the current crop of 12 launched in 2011 , with the rest in the years since—the short-term losses of emerging- markets bonds had regularly been much more moderate than those of emerging-markets stocks. Conversely, when emerging-markets stocks roared ahead, the bond gains had been more modest. Given how young these funds are and the tough environment they’ve had to deal with, it’s too soon to provide a definitive evaluation of their performance. Broadly speaking, though, the inclusion of bonds does seem to have moderated the performance swings of the funds. Venturing Outside the Boundary Yet another type of nontraditional option reaches beyond the commonly defined emerging-markets universe. In MSCI ’s view, frontier markets are a separate group of countries that rank even lower than emerging markets in terms of stock market size, liquidity, and openness to foreign shareholders, among other factors. There are now 15 frontier- markets funds, including mutual funds and ETF s (not including portfolios that focus on a single frontier market or region). Some restrict themselves to those countries defined as frontier markets by an index provider. Others also invest in some smaller countries that are classified as emerging markets rather than frontier. The frontier-markets funds do not have long records; the oldest ones launched in 2008 . They tended to perform well in 2013 and 2014 , but they endured heavy losses during the late- 2007 to early- 2009 global financial crisis and badly lagged conventional emerging-markets funds and indexes in the powerful rally that followed the end of the bear market. Like offerings in the other subgroups discussed in this

article, though, they can differ greatly in composition and performance from one another.

The key marketing pitch for frontier- and frontier/ emerging-markets funds is that these markets are largely ignored by global investors. That means promising companies can supposedly be bought at bargain prices, and the obscurity of frontier markets means that their performance has even less correla- tion with developed markets than emerging markets do. However, those attributes don’t necessarily make the funds attractive choices. For one thing, these funds tend to be expensive. Second, few have long enough track records to inspire confidence in their management teams and approaches. More- over, there’s no guarantee that markets at an early stage of economic development will continue to grow and prosper. Even if they do, there’s no assurance that such improvement will translate into robust stock market gains. Should investors consider adding a fund from any of these subgroups to their portfolios? It’s tough to make a case for the multiasset or frontier-markets funds. Nearly all of the funds in these subgroups lack long track records, and high expense ratios further detract from their appeal. Many in the small/mid-cap subgroup also suffer from these issues, but there are a few reasonably priced funds run by seasoned teams that might be worthy of consideration. A more persuasive case can be made to explore the geographically flexible subgroup. Three of these funds are in the Morningstar 500 : American Funds New World, Oppenheimer Developing Markets ODMAX , and Virtus Emerging Markets Opportunities HEMZX . Unlike funds from the other subgroups, a geogra- phically flexible emerging-markets fund could serve as an investor’s only emerging-markets choice rather than as a supplement to a traditional offering. That said, investors who like to make precise alloca- tions to various asset classes probably wouldn’t find these funds suitable, because they wouldn’t know from one portfolio to the next how much of the assets will be directly invested in emerging markets. K

Contact Bill Rocco at bill.rocco@morningstar.com and Gregg Wolper at gregg.wolper@morningstar.com