Funds Making Money in the World's Riskiest Markets

Rob Lutts, president of Cabot Money Management in Salem, Mass., routinely travels to Pacific Rim countries like Vietnam and Singapore ― so-called emerging markets ― in search of undervalued stocks. He's become so comfortable with investing outside the U.S. that as much as 30% of his aggressive growth portfolios are exposed to overseas markets like these.

"I am not trying to replicate the returns of some index," says Lutts. "I want to grow my clients' money."

Considering that the average emerging market fund lost 55.5% last year (the plain vanilla S&P 500 index fund lost 37.3%), Lutts' heavy weighting may sound surprising. To some, however, the move is prescient. As investors take their money off the sidelines they are investing in both U.S . equities and international ones. According to Lipper, the average emerging markets fund is up 33.3% this year. Such a performance is reminiscent of the category's pre-2008 levels when investors flocked to investments in countries like China and India.

Of course, it's hard to tell if the latest run will continue. SmartMoney.com decided to focus on emerging market offerings this week to see which funds are pulling ahead of the pack. There are 464 funds and share classes in our database that focus on emerging markets like China, India, Russia or regions like Latin America. We disqualified 401 for charging a sales load. We then searched for funds that had low fees and above-average three- and five-year track records. In addition, the funds needed to have a year-to-date return that exceeded the average international offering. In the end, we were left with just two funds.

Investing in emerging markets come with risks ― and rewards. In a good year, the typical emerging market fund can easily outpace their U.S.-based counterparts. That was certainly the case in 2006 and 2007 when China funds gained over 50% both years.

But there are plenty of stumbling blocks that can puncture that performance. Liquidity ― the idea that investors can build a position and then sell it when they want ― is often a problem especially in smaller emerging economies.

These markets can also be volatile as the hot money tends to exit as quickly as it enters. And investors must also consider geopolitical risks, like those playing out in Iran or North Korea.

All those concerns make picking the proper investment vehicle a difficult task. Lutts prefers to buy the shares of individual companies he comes across during his travels. Baidu.com (BIDU: 301.18, +8.03, +2.73%), the Google-like search engine company based in China, is one of his favorites.

But if individual stock-picking seems too risky, another way to play emerging markets is to invest in an ETF geared toward a particular country. The iShares exchange traded fund family has made it easy to either bet on regions or individual countries. For example, the iShares Turkey (TUR: 37.54, +0.12, +0.32%), South Africa (EZA: 46.20, +0.51, +1.11%), Brazil (EWZ: 53.61, +0.39, +0.73%) and Taiwan (EWT: 10.06, -0.08, -0.78%) funds each focus on those respective countries. Investors should just be mindful that ETFs such as these still come with a lot of volatility.

"We are allocating more money to emerging markets," says Robert Phillips, managing partner of Spectrum Management Group in Indianapolis. But, he warns: "It doesn't take a lot of money flows to influence prices."

Another option is an index fund. Vanguard Emerging Markets Stock fund (VEIEX) owns stocks in about two dozen emerging markets. Its largest holding is China Mobile. An alternative to an index fund is to pay for a managed offering in order to gain access to a manager who knows the ins and outs of overseas investing. We've included both types of funds in the table below.

The Criteria: The funds that made our list this week are classified in Lipper's emerging markets category. They are open to new money, require a minimum investment under $5,000 and charge an annual expense ratio less than 1.5%. Their three- and five-year track records put them in the top 40% of that category. In addition, they also had to beat the year-to-date performance of the typical international fund, which, according to Lipper, stands at 14.2% through Thursday. As usual, we did not include load funds.

Spanning the Globe

Ticker	Name	Assets ($ Millions)	YTD Return (%)	3-Year Average Annual Return (%)	5-Year Average Annual Return (%)	Expense Ratio (%)	Minimum Initial Investment
Source: Lipper Note: Data as of June 25, 2009
PRLAX	T. Rowe Price Latin America	1955.2	47.43	10.41	27.01	1.22	$2,500
VEIEX	Vanguard Emerging Markets Stock Index	5414.7	33.83	4.43	14.08	0.32	$3,000

Recipe

Fund Type = Emerging Markets *
Annualized 3-Year Return (%) = Display Only
Rank in Classification (%) (3 year performance) <= 40
Annualized 5-Year Return (%) = Display Only
Rank in Classification (%) (5 year performance) <= 40
Expense Ratio <= 1.5%
Load Fund (type) = No Load
Minimum Initial Investment <= $5,000
Open to New Investors = Yes
Total Net Assets ($ millions) >= 50
Year-to-Date Return (%) >= 14.2%