By JACK HOUGH
Your emerging-markets stock fund might need more exposure to emerging markets.
Many such funds have large exposure in markets that bear more economic resemblance to the U.S. than to China and India. They also tend to favor companies with global operations over those with local ones.
This hidden exposure to mature economies might crimp returns. Just as important, it can cause emerging-markets funds to behave much like U.S. ones. So far this year, the MSCI Emerging Markets index has returned 10.9%, versus 12% for the Standard & Poor's 500-stock index.
When an investor's holdings trade alike, it reduces diversification and increases risk. The solution isn't to sell broad emerging-markets funds but to complement them with more targeted bets instead.
The MSCI index, which has by far the largest market share in the field, has some quirks. Korea and Taiwan together make up about one-quarter of its market value, though the International Monetary Fund has considered both developed markets for more than a decade. Based on gross domestic product per person, they're around four times as prosperous as China and more than 10 times as prosperous as India.
Roughly half of the index consists of three economic sectors--finance, energy and materials--that depend as much on global trade as on local consumers. Its top holding, Korea's Samsung Electronics, collected more than half its revenues from the U.S. and Europe last year.
Brett Hammond, head of index research at MSCI, says the emerging-markets index is designed for high liquidity and low trading costs, and that Korea and Taiwan still resemble emerging markets.
The question, though, isn't just whether emerging-markets funds will do well but whether they will chart a course distinct from that of the S&P 500. That is part of the goal of diversification: having some holdings that zig when others are zagging.
For true diversification, investors should avoid getting all of their emerging-markets exposure from funds linked to the broad MSCI index. Instead, they should use them as part of a "core and satellite" approach, says Sameer Samana, international strategist at Wells Fargo Advisors.
Single-country funds--iShares offers many of them--work well for this purpose. Mr. Samana favors Malaysia, Thailand and Indonesia, which are "ancillary benefactors of China's growth," and Mexico, whose "key trading partner, the U.S., is outperforming Europe."
Small-company funds, by contrast, solve one problem but not another. They avoid relying too heavily on multinationals but can still be tilted toward mature economies. The WisdomTree Emerging Markets SmallCap Dividend (DGS)
For that matter, the S&P 500 itself gives plenty of emerging-markets exposure, because many U.S. companies do brisk business in China and elsewhere. But the same companies do business in slow-growth markets, too.
Here's a relatively new approach: economic indexing. The idea is to select emerging-markets portfolios based on where companies make their money, rather than where they're based.
EGShares Emerging Markets Consumer (ECON),
The fund's largest country weightings are Mexico, Brazil, South Africa and India; its biggest industries include food, beverages and retail. Year-to-date, it has returned 12.5%. Last year, it lost 5.2% while Vanguard MSCI Emerging Markets lost 18.7%. Fees are higher for the EGShares fund: 0.85% of assets per year, versus 0.2% for the Vanguard fund.
A final approach is to look for mutual funds whose managers let country and sector weightings fall where they may as they look for good stocks. William Rocco, an emerging-markets fund analyst at Morningstar, recommends two such funds.
Oppenheimer Developing Markets
Lazard Emerging Markets Equity