Admit it: You're afraid of emerging markets.
If there's one thing about which most experts agree, it's that the average investor is daunted by developing countries like China, India and Brazil, choosing instead to stick with investments in places they know and trust, like Canada and the United States.
But investors should consider emerging-markets plays as a way to diversify their portfolios, these experts say. To reduce volatility, investors should consider bonds or bond funds and exchange-traded funds that deal with emerging-market fixed income.
If you look at all asset classes over the last 15 years, "emerging-market fixed income is the best-performing asset class," says Christian Deseglise, the New York-based Managing Director at HSBC Global Asset Management.
Mr. Deseglise attributes that performance to a combination of high yields and improving credit quality. Yields, he says, "are about 5 to 6 per cent, depending on what fixed income you're investing in – a pretty high yield."
Credit quality can be seen in the fact that emerging markets are increasingly being given investment-grade ratings. The higher the rating, the less the risk of default.
Right now, bonds from China, India and Brazil are rated AA-, BBB- and BBB, respectively, by Standard & Poor's (everything above BBB- is considered investment-grade). By comparison, Italian bonds are rated BBB+, Portugal's, BB and Greek bonds, CC.
About 60 per cent of emerging markets are now investment-grade.
Investment-grade ratings are important for other reasons: They attract a lot of new investors, diversifying and stabilizing that market's client base.
"If a country loses investment-grade status, then there may be a whole host of investors who make having an investment-grade rating a minimum requirement for considering a market, just as a general guideline," says Nick Chamie, the Toronto-based global head of emerging markets research at RBC Capital Markets.
Improved ratings for emerging markets are also coming at a time when some developed countries are seeing their triple-A and double-A ratings downgraded. That helps emerging markets look "very, very good," Mr. Deseglise says.
Still, it shouldn't come as a surprise that the average investor fears emerging markets, says Tyler Mordy, director of research at Hahn Investment Stewards & Co., which specializes in ETF portfolios.
The average U.S. pension plan has about 4 to 8 per cent in emerging-market debt (or bonds) and 4 to 8 per cent in emerging-market equity, Mr. Mordy says, adding, "That's simply not enough."
He attributes that reticence to investors' perceptions, associating emerging markets with the political and economic crises of the past 20 years, while ignoring the fact that financial crisis has migrated to developed countries.
In the case of ETFs, his specialty, "they have always been linked to areas where the market is efficient and I think people perceive the emerging markets to be inefficient.
"But that argument falls flat when you look at the data."
So how does an investor determine what emerging markets to invest in?
Mr. Chamie suggests looking for economies with strong fundamentals – "those with improving growth dynamics, political stability, generally open and transparent markets – and a high yield never hurts.
For 2012, he says his firm is focused on Latin America and Asia, "particularly Latin America."
Mr. Deseglise says investors also need to consider currencies in their decisions. Investors, he says, can choose traditional emerging-market bonds, which are denominated in U.S. dollars and help remove a lot of the currency risk.
But there is another option: investing in emerging-market debt in local currencies. So, if you wanted to invest in Brazil, you have the choice of buying bonds in U.S. dollars or in reals. Mr. Deseglise says if you choose reals, you also receive local interest rates, which are often higher, plus the currency appreciation potential – "the fact that the real might appreciate against the dollar.
"We think this is a huge, huge part of the expected return or the return potential of investing in these markets," he says.
HSBC's Emerging Markets Debt Fund, one of a number of emerging-markets funds the company manages, invests half in so-called hard currencies, half in local currencies.
At Hahn, Mr. Mordy says their long-term pick is India. "I can't gush enough about it," he says.
He believes investors concentrate too much on a country's growth in choosing a place to invest and suggests looking for places that are democratic, allow freedom of speech, and also, as he puts it, "are making the transition to a post-mercantilism world." That means growth that is consumption-driven from a growing middle class, not based on exporting to the West, like China. "That's yesterday game, simply because Western economies can no longer absorb an endless supply of manufactured goods from East Asia."
Mr. Deseglise says that picking a place is important, but if you're investing in an emerging-market bond fund, your decision should be based on many of the same factors as picking any other mutual fund.
"You look at the track record, performance of the fund, performance against the index, the ability of the fund manager to beat the index, to provide steady and consistent outperformance."
He adds, however, that because of the higher risk and volatility of emerging-market funds, investors need to look a little deeper – to see whether the manager understands where he or she is investing. That means having local people on the ground who understand the local environment and analyze it.
They need people on the ground to "check the tires," he says. And, of course, "kick the tires."
Editor's note: This version makes it clear HSBC's Emerging Markets Debt Fund is one of a number of emerging-markets funds the company manages, and replaces a previous version.