Emerging markets were having their star turn in 2011 as financial advisers, retail investors and institutions poured tens of billions of dollars into stocks and bonds of countries such as Brazil, China, Korea and others, as Europe and the U.S. struggled mightily to emerge from their deep recessions.
But even as those markets surged from all the cash flowing to them, advisers began to see signs that some were getting overvalued.
Daniele Donahoe was one.
“We started to pare back China, Brazil, a lot of these countries that did well because I thought valuations were extended and they developed a lot of momentum,” said Ms. Donahoe, president and chief investment officer of Rinehart Wealth Management.
Things have clearly changed. Emerging markets have been seriously tested since last May, as a result of worries about Chinese economic growth and the effect of the Federal Reserve tapering its bond-buying program.
Analysts say the program, known as quantitative easing, depressed yields and sent investors across borders searching for enhanced returns. So when the Fed began in January to cut back its multibillion-dollar bond-buying program, emerging markets tumbled as investors fled.
The Fed is expected to trim its bond buying by $10 billion next month but may not end the program for many more months, leaving largely unresolved the question of how much that stimulus inflated emerging market assets.
A research note released Thursday by Bank of America Merrill Lynch analysts said the taper will “almost definitely” impact emerging markets. “Both real policy rates as well as market yields in [emerging markets] had reached levels that could hardly be rationalized without a reference to very low real policy and market rates in the developed world,” they wrote.
Facing both dropping currencies and stocks, investors pulled nearly $9 billion from emerging- markets mutual funds and ETFs last month, according to Morningstar Inc.
But some investors have been rewarded. Ms. Donahoe, for instance, recommended her clients ditch an index-tracking exchange-traded fund, the Vanguard FTSE Emerging Markets Fund (VWO), but maintain exposure through actively managed funds to navigate to values in other emerging and even frontier countries.
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The index tracker is down nearly 8% over the last year through Feb. 27.! But investors who loaded up, one year ago, on an alternative employed by Ms. Donahoe, Wasatch Frontier Emerging Small Countries Fund (WAFMX), have enjoyed returns of 11%.
It's more than stomach-churning volatility — always a hallmark of emerging markets — that's coming into play.
Investors are seeing widely disparate outcomes based on the countries and securities they — or their fund managers — choose.
In theory, an investor who had taken Ms. Donahoe's advice and put money into the Wasatch Frontier Emerging Small Countries Fund a year ago would be sitting pretty. Another who purchased the Wasatch Emerging Markets Small Cap Fund (WAEMX) would be sitting on a decline of more than 10% over the same time period.
Last month, Michael Swell, the co-head of global portfolio management for Goldman Sachs Asset Management, said that the fate of emerging markets could diverge, depending on their exposure to two waning forces: Fed liquidity and the Chinese economy.
Emerging markets with more exposure to China and commodities could do far worse than those that are not, according to a copy of a presentation Mr. Swell delivered last month at a New York conference of the Investment Management Consultants Association.
Despite the head winds, he and other analysts agree that emerging markets are broadly attractive, but the difference between countries is making security selection — bonds less exposed to ex
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