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Tread carefully on foreign shores Add to ...

The fast-money crowd says investors should look to the hot emerging markets for big stock market gains, but all that hype looks like a big red flag to some investors.

Those economies are growing fast and the long-run potential is huge given the low labour costs and large populations, but there are also political, legal and accounting challenges facing investors - not that those challenges can be ignored in the so-called developed markets, but they are often greater on foreign shores.

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And just trying to figure out investment strategies close to home in Canada and the United States is tough enough without compounding the difficulties by going abroad.

Investors considering an excursion into emerging markets may be looking for growth opportunities or undervalued companies, but in a connected world awash in cash it does not take long for one-time bargains to become pricey. And that is especially relevant considering the risks an investor faces abroad.

"We are concerned about the way foreign investors get treated in foreign markets," said David Baskin, president of Baskin Financial Services Inc. Canadian natural resource companies and major U.S corporations have found to their chagrin the risks of investing in Mongolia, Kazakhstan, Venezuela and countries in Africa and Eastern Europe. "We are very cautious about investing in areas where the rule of law is suspect."

In some emerging markets there are still warlords to deal with, civil unrest, dangers to employees and "shady stuff" going on, he said.

"In many cases, the numbers [accounting information]you receive from foreign countries you have to take with a grain of salt," Mr. Baskin said. "What are you buying?"

It's best to steer clear of these markets, he said. "Our first rule around here is 'Don't invest in what you don't know,' so we don't do it."

With the proliferation of investment products in recent years, there are a lot of options available to investors wanting exposure to emerging markets. There are mutual funds that are dedicated to investing in various countries and regions, although some of these carry hefty management fees due to the administrative costs. Some investors are opting for specialized exchange-traded funds, which often come with lower fees. Others might choose to buy major corporations operating in different countries and interlisted on a Canadian or U.S. exchange. Some investors are able to participate directly in a foreign market through a discount broker.

But investors looking for diversification by investing in emerging markets should think again.

As a result of the increasing globalization of markets, recent data compiled by Alec Young, international equity strategist for S&P Equity Research, shows that 82 per cent of the time the indexes of developed and emerging markets are now moving in the same direction. The correlation was only 40 per cent in February, 1993.

Furthermore, emerging markets can be volatile. The U.S. was the epicentre of the credit crisis and the S&P 500 fell 56.7 per cent from its peak in 2007. Emerging markets were down 67.1 per cent.

And while the volatility of emerging markets has declined recently, there are reasons to be cautious about this trend.

Investors have been showing a great deal of confidence - whether warranted or not - in the emerging markets, and some markets have already recovered 100 per cent of the losses triggered by the credit crisis debacle, said Andrew Pyle, a wealth adviser for Scotia Capital Inc. "A lot of cash in emerging markets has driven equity prices up and volatility down."

He said the current low volatility may be sending the wrong signals to investors. "Don't look where volatility is today, but where it can be."

The volatility of the of the emerging markets as measured by the Morgan Stanley Capital International (MSCI) Total Return Emerging Markets index -tracked by exchange-traded fund iShares MSCI Emerging Market Index (EEM-NYSE) - is 27.18, which is almost the same volatility as the MSCI EAFE index, which is based on developed markets in Europe, Australasia and the Far East.

However, at the height of the financial crisis, emerging market volatility was 190, compared with 130 in the global markets. The emerging markets are thinner, lack transparency and the level of confidence and knowledge is still better in developed markets, Mr. Pyle said.

While the emerging markets have staged a breathtaking recovery - the NYSE-listed EEM index has risen 132 per cent, compared with 68 per cent for the S&P - the EEM and S&P remain, respectively, 23 per cent and 27 per cent below their recent peaks.

As a result of the share price surge, companies in the emerging markets index are now trading at their highest levels relative to earnings since 2000, according to Bloomberg News.

Most investors will include emerging markets as part of an international portfolio, Mr. Pyle said. If one-third of an equity portfolio is invested in mainly developed markets outside of Canada and the U.S., a portion of that amount - probably less than 5 per cent of the overall portfolio for risk tolerant investors - could be in emerging markets, he said.

Mitigating some of the risk however is that the distinctions between the so-called top-tier emerging BRIC - Brazil, Russia India and China - markets and developed markets are fading.

The indexes of many emerging foreign markets are now made up of companies that mirror the performance of the same industries - oil and gas, mining and telecommunications - around the world. And investors in major international companies often have additional exposure to emerging markets through their sales and foreign subsidiaries.

For Canadian investors there are some other drawbacks to consider. Moving offshore means you will lose the income tax advantage on dividends paid by domestic companies and there is increased exposure to foreign-exchange fluctuations, strategists said.

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FRONTIER MARKETS

Some investors might want to explore beyond the conventional realm of emerging markets and strike out into the frontier markets in smaller countries in Eastern Europe, Latin America or the Middle East.

"The story going forward is many countries around the world are going to emerge," said Joe Kawkabani, portfolio manager for the Franklin MENA Fund, a $300-million (U.S.) Mideast and North Africa Fund.

"You have got to be early in that game," he said. There is an advantage to being in before the billions of dollars rush into those capital markets, he said.

"We are here to look for the long term," he said. This is an underappreciated large economic bloc that will become part of the emerging markets over the next 10 years or so, he said. Countries in the Gulf bloc such as Saudi Arabia, United Arab Emirates, Qatar and Kuwait need development capital and to open up to foreign investors, Mr. Kawkabani said.

The portfolio, which represents a collection of holdings in about 30 businesses across the region, includes consumer staple companies, a book store chain, a leading dairy and other businesses exposed to the consumer side of the economy and government infrastructure spending, he said.

"In our portfolio we have great names that are still undervalued [trading below cash per share and book value per share]" said Dubai-based Mr. Kawkabani. "We know the people and make the links." Investing requires knowledge of the culture, language and individual managements, he said.

Allan Robinson

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