From the September 2006 issue of Wealth Manager Web • Subscribe!

Sturdy Vessel

The emerging markets of Asia and Latin America have been booming lately. During the three years ending in May, emerging market stock funds returned 35 percent annually, ranking among the top categories tracked by Morningstar. That showing represents a sharp turnaround from the 1990s, when the Asian currency crisis and other problems decimated emerging markets.

Could the developing world soon face another severe meltdown? Probably not. Conditions have changed dramatically in the past decade. Countries such as Thailand and Brazil have tightened their belts, lowering budget deficits and building up foreign currency reserves. Standard & Poor's has taken note of the progress, giving investment-grade ratings to government bonds from Mexico and Russia, securities that were once considered junk.

Make no mistake, the emerging funds still pose more risk than those of the developed world; this spring many emerging stocks sank sharply. But a limited dose of emerging funds can diversify a portfolio, sometimes providing a boost when Wall Street is languishing. Which fund offers the sturdiest vehicle for traveling through emerging markets?

To find the best choice, Wealth Manager turned again to the eight-part screens developed by Donald Trone, CEO of FI 360, a consulting firm in Sewickley, Pa. The due-diligence process seeks to find funds that have more than $75 million in assets and are at least three years old. At least 80 percent of holdings must be consistent with the category, and the expense ratio must fall below the top quartile. One- and three-year returns must exceed the category's median, as must five-year results, if the fund is that old. Alpha and Sharpe ratios must also surpass the category's median.

The screens reduced the number of contenders from 196 to 18. The fund with the highest five-year returns was T. Rowe Price Emerging Europe and Mediterranean, but we excluded that choice because of its narrow focus. Other top performers--including Acadian Emerging markets and GMO Emerging Countries M--were closed to new investors. Another strong contender was Driehaus Emerging Markets Growth. In the end, we awarded the title to Lazard Emerging Markets, which avoided big losses in downturns and posted the highest Alpha and Sharpe ratio of any of the finalists.

Lazard achieved its steady record by focusing on stable companies selling at modest prices. Portfolio managers James M. Donald and John Reinsberg look for companies that can produce high returns on equity for sustained periods. Studying price-earnings ratios and other measures, the managers aim to buy when a stock is relatively cheap compared to historical experience. While the portfolio includes some growth stocks, the fund steers clear of high flyers selling at top prices

The resulting portfolio falls into Morningstar's blend box. The average price-earnings ratio of holdings is 12.3, compared to 14.3 for the average member of the emerging markets category. Because of the cautious discipline, the fund is often resilient. "During flat periods and significant downturns, we tend to do reasonably well compared to the benchmark," says portfolio manager James Donald.

The fund does not usually shine during roaring bull markets. Lazard lagged competitors in 1999, a year when expensive technology stocks led the market.

While the managers pick stocks one at a time, the fund seeks to limit risk by staying broadly diversified. No one name can account for more than 5 percent of assets. The portfolio has an upper limit for the amount of assets that can go into each country. For example, the managers will not put more than 30 percent of the fund into Korea.

Despite their caution, the Lazard managers are not afraid to go into countries that other funds shun because the markets are so tiny. In recent years, Lazard has scored strong returns in the small Egyptian stock exchange. A favorite Egyptian holding is Orascom Construction Industries, a construction and cement company with activities throughout the Middle East. The company has done work for the U.S. Army in Afghanistan. Orascom boasts steady profits and loyal customers. "Orascom is a very competitive producer with some of the lowest costs in the area," says Donald.

The fund has favored Indian companies, among them Satyam Computer, a software service company. A relatively small player in India, the company is often overshadowed by its better-known competitors. "Satyam has almost as high a level of profitability as the bigger companies, but it sells for a lower valuation," says Donald.

Once it buys a stock, the fund aims to hold on for several years, producing an annual turnover rate of 48 percent, lower than the figure for most competitors. The Lazard managers sell a stock when it becomes too expensive for their tastes. The fund owned Banco Itau, a Brazilian financial institution, for more than nine years. Catering to high-net-worth clients, the bank boasts returns on equity of more than 20 percent. The managers sold the stock a year ago when the price climbed.

While the cautious selling helps to cushion shareholders, Lazard suffered losses in May 2006 when emerging markets around the world tanked. Such dips can frighten investors, but they may also serve as buying opportunities. While many stocks dropped in the spring, emerging economies remained healthy. Factories and mines in Asia and Latin America continued churning out exports and producing growing profits. Such dynamic economies could produce solid returns for investors with the patience to hold through the ups and downs.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a business writer and regular contributor to Wealth Manager.

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