Emerging Wisdom

In recent years, investors have been better off investing in funds that track major stock market indexes than those under the guidance of managers, because most fund managers haven’t matched--much less beat--their performance.

Yet emerging-market investors who follow that strategy this year run the risk of placing too big a bet on Latin America--and missing out on what could be a powerful rally in Asian stocks, investment pros say.

Both major indexes that track the performance of emerging market stocks that Americans can easily buy--the Morgan Stanley Capital International Emerging Markets Free Index and the International Finance Corp.’s (IFC) Investable Composite Index--now give Latin America the biggest weighting, ahead of battered Asian markets for the first time in a decade.

That matters because many strategists, money managers and individual investors use these indexes as benchmarks when deciding where and how to invest.

“If they don’t want to lag the benchmark, then they’ll want to up their Latin American allocation if it’s not in line with the index,” said Ian Wilson, editor of Standard & Poor’s Micropal Emerging Market Fund Monitor.

Yet Wilson and other market watchers say that mirroring the indexes now could be a mistake. With the situation in Asia beginning to stabilize, many investors expect stock markets there will rally, reclaiming the top spot in the indexes by year’s end.

And even if they don’t, Latin America won’t offer much protection, even though so far it’s weathered the Asian storm with aplomb.

“The prospects for Latin America to perform well absent Asian stability are pretty slim,” said James Barrineau, Latin American stock strategist at Salomon Smith Barney in New York. “Asia really is the driver here.”

You’d scarcely know it by looking at the indexes.

Latin American stocks accounted for 42.2% of the Morgan Stanley index through the end of December. That’s up from 30.1% at the end of 1996.

Asian markets, by contrast, have shriveled, representing just 29.4% of the index now, down from 50.2% in 1996.

At the IFC, the private-sector arm of the World Bank, Asia’s weighting in its Investable Composite Index plunged to 24% as of December from 45% a year ago. Latin America surged to 41.4% from 34% in January.

The flip-flop, of course, simply reflects the beating Asian stocks have taken as the financial crisis triggered by Thailand’s devaluation of the baht in July spread throughout much of the region. The value of companies listed on South Korea’s stock exchange, for example, dropped 45% in the first 11 months of last year, said Peter Wall, a senior market analyst at the IFC.

“The extent of their financial crises has been such as to really melt them down in size,” Wall said.

Latin American stocks, by contrast, escaped the worst of the damage, though the “Asian contagion” afflicted emerging market stocks everywhere. Brazil, Latin America’s biggest stock market with a market value of $136.7 billion, slid 19% in the second half yet still posted a gain of 45% for the year thanks to a 79% jump in the first six months. Brazil alone made up 16.6% of the Morgan Stanley index as of December.

Both indexes are widely used as benchmarks by managers who specialize in emerging-market stocks. Micropal cites the IFC indexes reports comparing the performance of the emerging-markets mutual funds it tracks.

Some investors go even further. Both State Street Global Advisors and Barclays Global Investors manage funds that mirror the weightings in the Morgan Stanley and IFC indexes.

Over the years, that’s proven to be a profitable strategy, given how few managers manage to outperform the indexes.

This year may be very different.

“Going forward you’re going to under-perform,” Micropal’s Wilson said. “All of these markets always go in cycles. When they drop dramatically, they always rebound.”

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Leslie Hillman writes for Bloomberg News.