Seek reward, but don't forget the dangers

Last year the Russian stock market rose more than 100 per cent. South Korea and Norway both gained more than 50 per cent, and India's results were almost as eye-popping.

But every seasoned investor knows the little secret behind these stellar returns: In any given year, emerging markets can take a hit as big or bigger than these gains -- and the political risks may outweigh the economic ones.

"The Russian government stole my money," says Kevin O'Leary, a large private investor who runs four trust funds and co-hosts the show Squeeze Play on Report on Business TV. That's how he views the fate of his investment in the oil giant Yukos. The company's shares went to zero as the Russian government arrested and jailed its founder, Mikhail Khodorkovsky, for tax evasion.

Nevertheless, the loss wasn't enough to put Mr. O'Leary off Russia. "In the long run, Russia's a good investment," he says. "There's a big risk discount in the market. Instead of trading at 20 or 30 times earnings, stocks trade at 7 to 11 times earnings, and the people there have a strong desire to become wealthy."

Even if you're willing to make a bet on a company like Yukos, it's not as simple as going on-line and making a trade. Some countries have foreign exchange controls because they want domestic investors' money to stay in the country, and they don't want foreigners buying up their assets. At the very least, investors may be required to use a local broker, set up a local bank account, make trades via fax or phone instead of the Internet, and wait for confirmation.

Then there's the matter of fees: Count on 1 to 2 per cent in brokerage fees and stamp duty (a colonial hangover in many Commonwealth countries) plus the cost of currency conversion. "If you buy and sell an investment in the course of a year, you can expect to pay the better part of 5 per cent in fees," says Gavin Graham of the Guardian Group of Funds. "That's too high unless you plan to buy and hold, or you think your investment will double."

Mr. O'Leary bought into Yukos with ADRs, American depository receipts. They are issued when a bank takes local shares, deposits them in a vault and sells receipts that represent 5 or 10 shares. They are overwhelmingly concentrated on the New York Stock Exchange, are convenient and liquid, but they can trade at a premium or discount to the underlying shares.

"They're a great idea if you've done your research on the company," Mr. Graham says, "and you're satisfied that you're not getting nicked because the premium is too high."

These days, Mr. O'Leary is buying the ADRs of large, blue chip companies like the Swiss pharmaceutical giant Roche. When it comes to investing in countries like Russia, he says it's better to buy stocks in a basket.

His favourite vehicle for doing that is the ETF, or exchange traded fund. They are low-fee, passive investments that represent a basket of stocks in a given country, region or sector. They trade like stocks in Toronto or New York and are easy and cheap to buy and sell.

"All you need is a brokerage account," says Howard Atkinson, head of business development for exchange traded products at Barclay's Global Investors. "One trade and you're covered for a whole country asset class."

Mr. Atkinson says he's hearing less interest in Russia this year, despite last year's results. Investors seem to be focused on China and India because of the emergence of huge middle classes and massive infrastructure development.

Mr. Graham believes that governance is far more lax in China, and that's one of the main reasons why investors in domestic Chinese shares have lost 50 per cent in five years. He sees India as a much better long-term bet. "India is messy because it's a democracy," he says, "but the stock market has been going for 115 years, and they have the benefit of the legal system introduced by the British."

"Every portfolio should have significant exposure to India," says Mr. O'Leary, who has 1.5 per cent of his holdings in that country. As for China, he recommends playing the boom there by investing in Japan, which is a huge supplier, or by buying into Hong Kong.

The specialized world of commodities is also opening up to ETF investors. Deutsche Bank has just launched a hotly anticipated commodity index ETF. There are also ETFs based on gold bullion, and there will soon be funds for silver, oil and copper. Howard Atkinson cautions Canadians to be careful before loading up on these because 43 per cent of our composite index is made up of resource stocks. "From a Canadian standpoint, it's probably too much," he says.

It's getting more difficult to pick the right ETF because there are already nearly 200 on the market with more every week. Mr. Graham favours funds based on indexes constructed by Morgan Stanley or The Financial Times and Dow Jones.

ETFs aside, some investors still prefer actively-managed mutual funds. "In emerging markets where governance and legal standards can be lax, there's an advantage in having a manager who is conducting due diligence," says Levi Folk, president and managing editor of fundlibrary.com.

Still, Mr. Folk says it can be hard to judge the performance of these funds because "they're all over the map", with big swings year to year. He likes the Templeton Emerging Markets Fund because star manager Mark Mobius has a long track record and tends to focus on Asia.

The best 5-year performers in the emerging markets category are the Excel India Fund with annualized returns of 16.42 per cent, and the TD Latin American Growth Fund, which logged 15.4 per cent. However, the average equity fund in the sector earned only 11.2 per cent (annualized 5-year), lagging the MSCI emerging market index's average of 13.6 per cent.The bottom line is that exotic, alternative investments are now within easy reach of everyone. But investors need to avoid the temptation of chasing last year's winners.

Mr. O'Leary believes the key to international investing is diversification. This year he's putting his money on an emerging market fund that has already gone up 150 per cent from its 52-week low.

"I love Turkey right now," he says, "because of all the privatization that's going on there." He is invested in a New York-based ETF called the Turkish Investment Fund Inc., which is now trading close to its 52-week high of $30.30 (U.S.).

Mr. O'Leary is very enthusiastic: "Turkey could well be the story for 2006-2007."

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