A Taste for Risk—Again

Date: Monday, July 6, 2009
Author: Shefali Anand, The Wall Street Journal

It’s amazing the difference a rally can make in investors’ appetite for risk.

A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They’re back to buying relatively safe investments like high-quality corporate bonds. But they’re also pouring money into the riskiest investments. They’re lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds—making these among the 10 best-selling mutual-fund categories this year.

“Some have said, ‘Well, if we’re going back in [the market], let’s take a real risk,’ ” says Iain Clark, chief investment officer of Henderson Global Investors.

Some market watchers think these investors are trying to quickly recoup their massive losses from last year. Or they believe these investors are simply chasing performance.

Whatever the motivation, though, they may be overdoing it.

The pros warn that some of these hot foreign and bond markets may be due for a breather, since they have run up significantly in such a short time. What’s more, experts advise investors against suddenly loading up on any type of investment that would veer them away from their long-term asset allocations.

In the first five months of this year, investors poured a net $4.9 billion into diversified emerging-market mutual funds, more than reversing the net $2.6 billion they pulled out in all of 2008, according to Morningstar Inc. In comparison, mutual funds that invest in large U.S. stocks have had outflows of $11.2 billion, following a $52 billion outflow last year.

Meanwhile, natural-resources and precious-metals funds combined have had inflows of $7.8 billion so far this year, versus an outflow of $2.1 billion last year. As for junk-bond funds, investors have put in $12.6 billion, after adding $1.2 billion in 2008.

Many investors are also buying safer investments, like high-quality municipal-bond and corporate-bond funds. Intermediate-term bond funds have had the highest inflows this year, of about $41.6 billion, according to Morningstar.

But a growing group of investors are going to the other end of the risk spectrum.

Murray Schofield, a retired orthodontist in Arizona who sold most of his foreign investments in the second half of 2008, has been buying emerging-market funds, and funds dedicated to China and India, since March. He now has 23% of his portfolio in funds that invest in these stocks. “I have to recapture part of my losses,” says the 84-year-old. “Otherwise I’d be more conservative.” His portfolio is up 20.4% for this year, following a 44% loss in 2008, he says.

Here’s a closer look at the outlook for three hot—and potentially risky—fund sectors.

EMERGING MARKETS

Stock markets of developing countries like India and Brazil have gone through the roof since early March, reversing some of their declines from last year. The MSCI Emerging Markets Index is up about 34% for the first six months of the year, after losing 54.5% in 2008. Some niche markets have had wilder swings. Russia’s benchmark RTS index is up 56% for the year’s first half, after losing 72.4% in 2008.

What’s changed? Not only do investors have a greater appetite for risk these days, they’re also more optimistic about the economic outlook for some of these countries. In China, the world’s third-largest economy, the government’s massive stimulus is starting to take effect. While exports are still down, internal growth is gaining strength. Meanwhile, commodity prices have been on the rise, improving confidence in Brazil and Russia.

Despite hot performance for emerging-market funds so far this year—an average 33% return—some money managers say caution is in order. While they’re optimistic that emerging-market economies will grow at a much faster rate than the U.S. over the next several years, some worry about the recent explosive rally in these markets.

“It’s been the lower-quality, the riskier companies that have done better this year,” says Simon Hallett, co-portfolio manager of the Harding Loevner Emerging Markets fund. “Emerging markets have probably overshot in the short term.”

Investors, these managers warn, should be prepared for a bumpy ride ahead. “There’s going to be quite a bit of volatility,” says Andrew Foster, manager of the Matthews Asian Growth & Income fund.

Generally, financial advisers aren’t ratcheting up their long-term allocation to developing countries, keeping it typically between 4% to 10% of an average client’s portfolio. If you do choose to plunge into emerging markets, remember: You may not need a dedicated fund to have exposure to these markets if you already own a broad international- or global-stock fund. Some of these funds buy into emerging markets; check a listing of the most recent holdings to see where you stand.

COMMODITIES

The price of oil has been on a roller coaster since 2007, hitting an all-time high last summer and then losing more than half its value over the next several months. Since February, however, it has reversed course, more than doubling.

Some precious metals have been relatively less volatile. Gold lost around 25% in a four-month period last year and has since regained that loss, coming back to where it was a year ago. Stocks of companies that operate in the commodities space, like drillers and gold miners, have fallen and risen even more steeply than the underlying commodities.

A couple of factors are behind these moves. Last year, as the global economy cooled, so did demand for commodities, reducing the prices for oil and natural gas. And many large investment funds were forced to sell their commodity holdings to meet investor redemptions, which further depressed prices.

Recently, investors have been piling into commodities, partly because they fear impending inflation, as the U.S. government prints money to deal with the financial crisis. “Big swings in inflation all come from commodity prices, so they’re a good inflation hedge,” says Mihir Worah, manager of the Pimco CommodityRealReturn Strategy fund.

What’s more, a number of people who were sitting on cash waiting for markets and the economy to improve have rushed in lately. The upshot: The average naturalresources fund, which invests in stocks of energy-related companies, is up 15% so far this year, after losing 49% in 2008. Precious-metals funds, which buy stocks of companies in metals-related businesses, are up on average 19%, following a 30% decline last year.

What do the pros think? Fred Fromm, co-manager of the Franklin Natural Resources fund, is bullish on commodities over the long term but says challenges remain in the near term. There’s more supply than demand for oil, which typically leads to lower prices. Mr. Fromm says until there’s confirmation that demand is picking up or supply has slowed down significantly, the rally in prices might not be sustained in the near term. Pimco’s Mr. Worah says a dip in the market wouldn’t surprise him, given the recent gains in commodity prices.

Advisers typically use commodities as a diversifier for a small portion of their clients’ portfolio. Richard Schroeder, a financial planner in Amherst, N.Y., allocates 5% of his clients’ portfolio to commodities, through broad funds like Pimco CommodityRealReturn and Ivy Global Natural Resources.

JUNK BONDS

Bonds of companies that have low credit ratings have been on a tear lately, after a crushing 2008. Mutual funds that invest in these bonds have gained on average 23%, making them the second-best-performing bond-fund category, after bank-loan funds, which are up 26%.

Last year, junk-bond funds lost 26%, making them among the worst performers in bonds. Investors feared that the financial system was on the verge of collapse, and companies wouldn’t be able to repay debt. Lately, investors have turned to these bonds in search of high returns and yields of 11% or more. To tap into this appetite, fund companies have been launching offerings that invest in high-yield and distressed bonds. (See related article.)

But long-term fund investors should weigh the risks before buying. Given the weak economy, analysts expect that an increasing number of companies will be filing for bankruptcy protection and defaulting on their debt.

And the amount of money that bondholders can recover from a defaulted company could be meager. Consider the recent bankruptcies of General Motors Corp. and Chrysler LLC; the Obama administration pushed through restructurings that left bondholders with practically nothing.

Given all that, as well as the recent run-up in bond prices, money managers are approaching junk bonds with caution. Dan Shackelford, manager of T. Rowe Price New Income fund, had been buying such bonds late last year when they appeared to be cheap across the board. But he’s more selective now. “At some point, we do a gut check here and say, ‘Have things fundamentally improved that much?’ ” he says. His view: “A lot of the value has been squeezed out.”

Some advisers believe that investors are better off buying the stocks of companies that issue these bonds, since the bonds don’t provide the safety that high-quality bonds and government bonds do. Others think there is some diversification benefit to the bonds, and they like the high yields.

“There’s a fair amount of risk there, but we’re OK about taking that risk with a small portion of our portfolio,” says Tom Orecchio, a financial adviser in Old Tappan, N.J. He allocates about 3% to 8% of his clients’ portfolios to such bonds, depending on their risk appetite.

--Ms.Anand is a staff reporter in The Wall Street Journal’s New York bureau. She can be reached at shefali.anand@wsj.com.