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Emerging Market Equity Funds Stage a Comeback

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With 2016 officially half over, global equity funds are reflecting a story of mixed performance. Some groups are up, while some are down and geographic location is driving market returns. Thus far, Asia and Europe are lagging, while North and South America are outperforming on a relative basis.  

Latin American equity funds tracked by Morningstar are ahead by 22.53% year to date and are leading all regions. Countries that make up this group such as Brazil, Mexico and Peru are part of the broader emerging markets group, which is also outperforming.

Although broadly diversified emerging market funds have lagged developed markets over the past several years, the tide is changing.

Diversified emerging market funds are ahead by 4.85% this year, led by the hot performance of funds like the Invesco Developing Markets (GTDDX), 17.11%, and the Brandes Emerging Markets Value (BEMAX), up 15.62%.

GTDDX has most of its equity exposure to Asia (46.90%) and the Americas (29.59%), while BEMAX has taken a similar approach by limiting exposure to Europe. Both funds are top-performing emerging market funds so far this year.

Despite the ripple effect of higher stock market volatility, funds that invest in large international companies have not been a haven of safety. As a group, diversified foreign blend funds with large-cap exposure have lost 4.90% in value.   

Regionally, European stock funds are among the worst performing group and have lost 5.07% year to date. The bear market in European financial stocks has stung and the sector is down more than 25% this year.

Meanwhile, England is trying to stabilize its crashing currency.

For the first time since 1985, the British pound sank below $1.30 against the U.S. dollar. The pound is down more than 13% since the June 23 U.K. referendum to exit the European Union.

Over in Asia, Japanese stock funds have been hurt by a strong yen.

Japanese stock funds have declined 1.03% year to date and are down almost 5% over the past year. The July 10 election for the House of Councillors is projected to result in a victory for Prime Minister Shinzo Abe’s Liberal Democratic Party, but even that is not expected to reverse dull the perception that the broader benefits of Abenomics are stalling.

As the risk of overseas investing becomes ever more complex, hidden pitfalls abound. Angry citizens, fast-changing politics and swooning currency prices, as we’ve seen this year, can have an outsized impact on stock market returns.

To address these obstacles, Morningstar debuted its Global Risk Model, which analyzes 36 factors across style, sector, region and currency characteristics to help investors understand an investment’s factor exposures.

“Risk analysis is paramount to the investment decision-making process, said Warren Miller, head of asset management software for Morningstar, in a press release announcing the new risk model.

“Our model uses unique factors such as sustainable competitive advantage and ownership data to provide a powerful lens with which to understand the risk of a stock or portfolio. In addition, our risk model methodology incorporates ‘fat tails,’ or extreme events, among investment returns when forecasting the distribution of future returns, instead of relying on a normal distribution.”

Morningstar’s risk model examines more than 40,000 stocks and 10,000 equity fund portfolios in the company’s database and then builds a comprehensive forecast of future returns for various time horizons based on all 36 factor exposures.

Miller added, “Investors can use the risk model to research securities and construct portfolios to make more informed investment decisions about risk and suitability, at a more granular level.”

If there’s one thing 2016’s mixed performance record has shown, it’s that blindly investing in the very largest foreign stock funds doesn’t necessarily reduce risk or protect capital. Investors also shouldn’t forget the strong relative performance of U.S. stocks as the S&P 500 (SPX) approaches a record close. It’s up 4.2% year to date.  

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