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Emerging Markets: Tempting but Dangerous

Let's start today's column about emerging markets with a little story about a man we'll call Big Jim. Big Jim lived in a cabin in the woods, and when he came home one day, he saw a family of grizzly bears eating his breakfast, drinking his liquor and smoking his cigarettes.

Well, ol' Big Jim ran roaring and yelling right at those grizzly bears. And you know what happened?

The bears ate him, that's what - and that's why it is better to run away from danger sometimes. If you own an emerging markets fund, it might be time to take some money out and skedaddle. But if you're really tempted by emerging markets, you might consider an emerging markets debt fund instead.

Emerging markets are stock markets in small or young markets, such as Russia, Brazil, India or China. These markets have been on fire this year: Indonesia's stock market has rocketed 90.5 percent, and India's market has leapt 87.1 percent. In fact, all the emerging markets except one (we're looking at you, Morocco) are up this year.

The average emerging markets fund has soared 74.3 percent this year. Some of that performance comes from the falling value of the U.S. dollar on the currency markets. Although a falling dollar is bad if you're visiting Bolivia, it's good if you stay at home and send your money abroad.

For example, suppose you bought 1,000 euros during your last tour of Europe, and stuffed your euros in your sock drawer. One euro equaled $1.30 at the time, so you spent $1,300. Now, however, the euro equals $1.49, so your euros are worth $1,490 - a 14.6 percent profit. The currency effect has turbocharged some countries' stock markets. For example, Brazil's market has gained 119.8 percent this year in U.S. dollars, vs. 61.1 percent in the Brazilian real.

Emerging markets do have solid reasons behind their gains. Many emerging markets, such as Indonesia and Brazil, are primarily exporters. When the U.S. markets melted down, exports slowed dramatically, and emerging markets funds got clobbered, plunging 58 percent the 12 months ended February, according to Morningstar, the fund trackers.

But emerging markets also didn't have the kind of consumer debt and mortgage problems that the U.S., Europe and Japan suffer from, either, says Alec Young, equity strategist for Standard&Poor's. When export demand started to pick up, so did emerging markets.

And, Young says, emerging markets sell for about 13 times 2010 estimated earnings, which makes them relatively cheap compared with developed markets. The Standard&Poor's 500-stock index sells for about 14.5 times 2010 earnings.

Nevertheless, you should be wary:

Volatility. Anytime an asset class has rocketed this far, this fast, you should worry that it's due for a fall. This is particularly true for emerging markets, which are far more volatile than domestic U.S. stock funds. "A 20 percent decline in emerging markets is like an 8 percent fall in the U.S.," Young says.

Popularity. Today's wildly popular funds are tomorrow's outcasts. Investors have poured about $22.5 billion into emerging markets the past 12 months, according to Lipper, which tracks the funds. In contrast, they have yanked $13.5 billion from funds that specialize in Europe, and $54 billion from large-company U.S. funds.

Faddishness. Typically, as emerging markets heat up, fund companies start rolling out funds that specialize in smaller, less stable markets, called frontier markets. This never ends well. So far this year, we've seen the introduction of the Global X/InterBolsa FTSE Colombia 20 exchange traded fund and the Market Vectors Vietnam ETF.

If you decide to invest in an emerging markets fund, set a target percentage of your portfolio and trim when your holdings get too large. Somewhere between 5 percent and 10 percent is enough for most people.

If emerging markets stocks seem too risky, consider investing in emerging markets debt funds. Make no mistake: These, too, are risky. But bonds tend to be less risky, if only because their regular interest payments can cushion a downturn.

And, says Matt Ryan, manager of MFS Emerging Markets Debt fund, many countries have trimmed their national debt - and some even run surpluses. "They have been doing what we have said they should do, and not what we have done," Ryan says.

The top-performing emerging markets debt funds are in the chart. But no matter how tempted you are by emerging markets debt or bonds, remember that the next bear could eat up your gains.

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