Rebuilding Your Portfolio: What's Hot in Mutual Funds

Aside from what investors have moved into of late (largely a combination target-dated funds, index funds and money market/bond funds) the only way an investor could successfully rebuild their portfolio to what it may have been is with risk. Assuming no risk leaves you watching a very safe investment grow at a safe investment pace. That pace is unfortunately not moving as fast as some of our plans.

Risk, as we have discussed so many times in the past has no obtained a sort of disreputable mantle, one that automatically assumes that loss is the greater part of the equation that it should be. If you have been following our conversation about some of these risks on our retirement planning blog, you will understand that not only is this kind of thinking perfectly normal (albeit not well understood by the folks that have tested these concepts) it can cripple your efforts to move ahead at a swift enough pace to overcome inflation and taxes.

So the question of why investors do what they do remains viable and subject to each individual's predisposition. But there are things you can do to help boost your earning potential while you begin to readjust your risk outlook.

Over the next several posts, we will be looking at the different types of markets that will offer you some of this potential. Emerging markets are offering just such a possibility.

What are emerging markets?
First, lets identify the risks involved with these types funds. The countries that are usually associated with these types of investments seldom have strong banking systems, stable governments that ensure the success of the business interests it protects, and relative overall economic predictability. Those risks can take an investment on a wild ride depending on the as little as change of the wind.

But what is currently be labeled as emerging might surprise you. China, Russia and India can fall easily into this category and have begun to make up a large portion of the more successful emerging market funds. The problem most investors have when choosing an emerging market fund is how to benchmark them.

The real questions is: do they need to be benchmarked? It is difficult enough to apply benchmarks to actively managed funds in the US for two reasons. Actively managed funds want to be benchmarked against the most attractive index possible while index funds do little to reflect the underlying holdings of all but the largest funds that are actively managed.

This becomes doubly difficult for index funds that track emerging markets. Including those three giants into the emerging market index could greatly skew how these markets are performing when looking for funds that consider diversification what they are seeking to achieve.

Consider Vanguard's Emerging Market ETF (VWO), an exchange traded funds that acts like an index fund but trades openly throughout the day. As of a year ago May 31st, the fund held 11.1% of its total holdings (of eight hundred companies) in China. A year later, the holding has grown to 18.6%. Brazil, the economic superpower of South America makes up a total of 15% of the fund, down from 16.9% a year ago. Other major holdings in the ETF include Korea (12.4%) Taiwan (12.4%) and India (7.7% - up 1.2% over the previous year).

Now consider what Vanguard holds in its Vanguard Total International Stock Index Fund (VGTSX). An index such as this spreads the risk of international investing into many of these emerging markets but does so in a much more broad style. With 1752 companies in the index (and ridiculously low expenses - 0.34%) your exposure to risk is lessened but not avoided completely.

The lesson to be learned here is simple: as with all of your stock funds, diversification begins when you own dissimilar holdings. When too many stocks in a fund begin showing up in other funds you own, you risk having too much exposure to one type of investment. This can be one of the major pitfalls of international investing and funds that are considered emerging markets.

Emerging market funds should not contain well-developed nations outside of the US and European such as India, China or Russia and in many instances, Brazil can be included in this group. Although these countries often play a role in the developing nations they are closest to, they in themselves are not emerging (and because of that, can and should be purchased for less than emerging market funds often charge).

(Note to Reader: I do not often suggest indexing funds inside of a retirement portfolio. But in this case, it is prudent. The tax gains can be large and worth keeping in these types of funds. US stock indexes, in particular the index that tarcks the S&P 500 should be kept outside of your retirement accounts.)