Investor News: Asia offers rewards and risks

If you're a market-watcher, you've noticed the headlines: "China's stock market hits record," or "China's central bank concerned about stock bubbles." Over the past 12 months*, China's market grew at nearly 90 percent. Other countries in this part of the world also have performed like stars over the same 12-month span. The Indian market grew over 70 percent, while the Philippines and Malaysia are hovering around 45 percent.

Compare that to the US's 3 percent growth in the same time period, and it begs the question, "Why shouldn't I invest in Asian regional markets?"

Plenty of investors have asked the same question, and have answered by pouring money into the area. Cash invested in Asia/Pacific stocks—which includes those of China, Japan, the Philippines, India, Australia, and more—reached $18 trillion in April of 2007, as compared to $16 trillion in the domestic New York Stock Exchange. Asian companies now represent a significant portion of the universe of stocks available to investors.

Clearly, the area is a hotbed for investing, with over 100 specialized funds and exchange-traded funds (ETFs) available. It deserves your attention, but doesn't come without risks.

Why the phenomenal growth rate?

China's gross domestic product (GDP) has grown at a blistering pace: around 10 percent in each of the past few years. It's expected to slow only slightly in 2008. India's economy has grown at over 9 percent in 2005 and 2006. Compare these figures to the 2006 US GDP of just 2.5 percent and the potential these developing countries hold compared to a mature economy like ours is obvious. The growth in the region's emerging markets is driven by several factors. Each country is different, but overall trends include increasing consumer wealth and subsequent spending, massive infrastructure development, and booming exports.

Much is driven by China's role as a low-cost labor supplier, not only for US companies, but for businesses around the world. China's output is so tremendous that a single manufacturing facility in the city of Shenzhen reportedly employs well over 100,000 workers. The results of the staggering growth are evident in the city's dozens of skyscrapers and hundreds of factories, and the accompanying air and water pollution that foreign visitors and the Chinese alike endure.

China's urbanization is a key factor in continuing growth, according to Lei Wang, co-portfolio manager of Thornburg International Value, a broad-based international fund. "Millions of Chinese still live in rural locations, but are moving from farmland to cities and they need places to live, food to eat, and jobs to fill. Increasing demand for Chinese goods will create those jobs. China supplies not only its own people but the entire world. Just look at the number of people who wear Nikes."

Korea and the Philippines are among other emerging markets that hold promise now and for the future. Industrial companies are driving the positive Korean stock market trend. Steel and specialty chemical companies have been performing strongly, and shipbuilders are doing well because of both rising ship prices and increasing overseas orders. The Philippines' growth has been spurred by solid electronics exports and a strong local currency. In addition, significant amounts of cash are flowing into the country from overseas Filipino workers, which is serving to boost local demand for goods.

Outside of emerging markets, Wang likes Australia's prospects because of its coal, iron ore, and copper reserves, and its proximity to Asian countries. "Australia's become a commodity house for the rest of Asia. It's close enough to China and India that it'll benefit from all the demand for raw building materials." (For more on how you can make money in commodities, see "Your Money: Commodities demystified?" in our Aug. 17, 2007 issue.)

Mark Headley, longtime portfolio manager at Matthews Asian Funds, likes Japan's prospects. While the Nikkei stock market certainly hasn't set the world on fire over the last nearly 20 years, Headley is optimistic about where the Japanese economy is headed. "It's on solid footing, and Japanese companies are being run more efficiently, in a shareholder-friendly manner." Jim Stack, president of InvesTech Research, echoes Headley's sentiment. "Investing in the Nikkei is one of the more conservative ways to invest in Asia's growth. It's a more mature economy and the accounting standards are more stringent."

Take advantage of the diversification factor

When the US market's not doing well, it's likely these stocks can prop up your returns. The returns of small-cap Asia/Pacific stocks, for example, often behaved unlike those of the S&P 500's from 2001 to late 2007. Yet in an increasingly global economy, larger markets tend to move together. Over the same time period, the MSCI EAFE (Europe, Australasia, and the Far East) Index mirrored the US markets much more frequently. But advisers agree that the simple act of spreading your investments over a broader market is still a powerful diversifier by itself.

Investors in these countries were rewarded in recent years when the US market was down. When the S&P 500 lost over 22 percent in 2002, the Matthews Asian Growth and Income Fund outperformed it by more than 30 percentage points. In 2001, when the S&P lost almost 12 percent, Matthews Korea Fund rewarded investors with a whopping 71 percent return.

On a longer-term basis, Asia/Pacific's returns have been crushing those of the US markets. MSCI Barra country indexes show annualized five-year price increases of around 50 percent in India and Indonesia, as compared to the US's 10 percent. But these great returns don't come risk-free. In early June, China's Shanghai Stock Exchange Composite Index dropped 15 percent over just four trading days in response to an increased stock-trading tax.

Sidestep the many dangers

The biggest risk that experts see in investing in Asia/Pacific companies right now is that you could be riding what may be the crest of a lengthy bull market. And after a wave crests, it crashes. Jim Stack says, "Asia is a great place to invest, but now is not a great time to overdo it because we've gone so far without a healthy correction or bear market."

We've already seen the Chinese market stumble a bit only to come roaring back. The question is whether other markets will follow if another dip occurs, and if so by how much? William Samuel Rocco, senior fund analyst at Morningstar, the fund-and-stock rating and research company, notes that "a crisis in one of the major Asian markets could well ripple throughout the entire area." That's why many experts suggest using dollar-cost averaging to get your feet wet: Instead of plowing a significant part of your stash into a broad-based diversified Asia/Pacific fund right now, try diverting just a few hundred dollars a month. That way, you won't miss out entirely if the market still has more heights to climb, and you won't be losing a ton of cash if it suddenly plunges. And, if it does dive, then your disciplined approach will have you buying shares at lower prices.

Another caveat: Don't automatically assume that projected GDP growth will directly translate to stock market gains. "The Chinese economy could continue growing at 10 percent a year, but their stock market could still implode," says financial planner Richard Crum, of RS Crum in Newport Beach, CA. In fact, the Shanghai Composite Index had quadrupled in less than two years before falling in response to the government's cooling attempts and then quickly rose again. Yet the fall wasn't heralded by any drop in the country's GDP: That figure continues to grow at a double-digit pace.

Besides timing and market risk, there are significant political issues to consider. As recently as last September, Thailand's controversial prime minister was overthrown by a military coup. Around the same time, investors feared South Korea because of growing populist sentiment and hostility toward foreign investors. Jim Stack enumerates the problems affecting Chinese investments: lack of accounting transparency and regulation, corruption, and limited liquidity. "As long as the Communist government is such a dominant force in the stock market, these problems will continue to make China a high-risk investment."

Where these investments belong in your portfolio

Don't venture into buying these stocks individually; instead let mutual fund managers decide which companies belong in your portfolio. (See the chart for several funds our experts favor.) And don't shift a large portion of your holdings to these countries hoping for huge wins. Experts agree that the percentage earmarked should be relatively small. William Howard Jr., a financial planner in Memphis, recommends just 3 to 5 percent of your portfolio be focused on emerging market funds, a category which includes Asia/Pacific companies.

Moreover, don't foray into the region until you're already well-diversified both domestically and internationally. To Bill Rocco, that could mean that you already own at least two international funds-perhaps one developed market large-cap fund and another that's either focused on smaller caps or a broad-based emerging market fund, for example. Only after that should you take a look at some of the funds that focus on Asia. Just be sure, Rocco notes, that your mix of holdings complement, and don't duplicate, each other.

Narrow the field to funds whose manager has studied the region for a long time. One such long-term manager, Frances Dydasco, has run a sector favorite, T. Rowe Price New Asia Fund, for over a decade. Based in Singapore, and previously in Hong Kong, she has nearly 20 years of research and financial analysis experience.

While the astounding returns of several single-country funds are tempting, don't invest any of your money if you're not willing to lose it. Headley says, "Ask yourself, if the fund falls 50 percent are you going to buy more shares of it or are you going to sell? If the answer is sell, then you shouldn't buy it in the first place." Rocco adds, "Don't focus on the best a single-country fund could do; think about the worst it could do."

Be sure you have a long time horizon before investing in any single-country Asian fund, and above all else don't try to time the market. In other words, treat it the same as you would an individual stock. Headley offers this sage final advice: "You should be invested in this region, but don't get intoxicated with the returns of the last few years. Don't get too excited when these countries do well, and don't get too depressed when they do badly. And don't bet anything on single-country funds that you aren't willing to lose."

*Through the middle of November 2007, according to Morgan Stanley Capital International.

Winning Asia/Pacific funds