MONEY mutual funds

“Green” Funds Think Apple is Ripe for the Picking

Aerial of the Main Building of Apple's new Cupertino campus.
Aerial of the main building of Apple's new Cupertino campus, powered by renewable energy. City of Cupertino

Apple — which has been criticized in the past for greenhouse gas emissions, the use of toxic materials in its products, and working with suppliers who hire underage workers — has adopted a slew of new green policies recently and now earns better marks from groups such as Greenpeace.

For managers of environmentally aware mutual funds, the recent improvements bolster the appeal of a company whose shares are considered green in another way — by making money.

AAPL Chart

AAPL data by YCharts

While the iPhone maker’s stock is up more than 15% this year, Apple shares are still considered attractively priced, given the company’s massive earnings. This, plus improving environmental performance make Apple “the one stock you just can’t ignore,” says Anthony Tursich, senior portfolio manager of the Portfolio 21 Global Equity Fund, a so-called green fund that bought Apple in 2011 after the company began providing more emissions data.

Tursich’s biggest holding is another tech giant, Google , which he bought only after the search engine company made progress on renewable energy.

Environmental fund managers may be broadening their shopping lists in part because they have more money to deploy: For the 12 months ended April 30, investors put $1.9 billion of new money into the 72 funds tracked by Lipper that use environmental criteria in their investment decisions.

That’s still tiny relative to the $247.6 billion that went into all U.S. equity funds, but it represents a 5% inflow that Lipper research head Tom Roseen said was significant. The bulk of the new money, more than $1 billion, went into the dominant $9.5 billion Parnassus Core Equity Fund, Lipper said.

Apple is the top holding of the Parnassus fund, which bought most of the shares in 2013, the year the fund rose 34% and beat 72% of peers, according to Morningstar. Through June 13 the fund was up about 7% in 2014, beating 87% of peers.

Apple is also the top holding of the Calvert Equity Portfolio and the Green Century Balanced Fund, and is the third-largest stock in the Pax World Balanced Fund, according to the funds’ latest filings.

Fund managers cited a mix of reasons for warming up to Apple, including reforms pushed by Chief Executive Tim Cook and the stock’s outlook. It is up 15% in 2014 on enthusiasm for its iPhones and other pending products, as well as a stock split and a dividend increase.

In the past, Apple had taken hits from activist groups like Greenpeace — which in 2010 called it “very weak” on climate and emissions matters — and has faced scrutiny over the hiring of children at factories of suppliers that make its products.

It also earned a bottom score of “4” on its carbon footprint from the Boston sustainability advocacy group Ceres. Ceres senior manager Kristen Lang said Apple had not released enough information to get a better score, such as making public its targets for reducing greenhouse gas emissions. Google received a higher score of “2” from Ceres, which praised its spending on renewable energy.

Among other things, Greenpeace said Apple was moving too slowly to stop using hazardous materials like polyvinyl chloride plastic — often used to insulate electrical cables — and brominated flame retardants in its products. Critics worried both materials could be released from products during use or when older computers or power cords are disposed in landfills.

In recent years, however, Apple has made changes and improved its image with environmentalists. In April, Greenpeace called Apple a leader for things like powering data centers with solar arrays, wind farms and water. Ceres’ Lang said Apple might get a higher score currently based on steps it has taken since data for her groups’ report was collected last fall.

In addition, Apple this year reported a sharp decline in number of underage workers hired at its supplier facilities abroad.

Apple — whose board includes environmentalist and former U.S. Vice President Al Gore — also last year hired former U.S. Environmental Protection Agency head Lisa Jackson to oversee areas like cutting toxins from its products.

Asked about the Ceres score, Apple spokesman Chris Gaither said the company powers 94% of its global corporate facilities with renewable energy now, up from 35% in 2010. He added: “Of course, the cleanest energy is the energy you never use, and that’s why we’ve made efficiency such an important feature in Apple facilities and products.”

MONEY 401(k)s

Do I Really Need Foreign Stocks in My 401(k)?

Foreign stocks are supposed be a great way to diversify and get better returns. But these days? Not so much.

It’s long been a basic rule of retirement planning—allocate a portion of your 401(k) or IRA to international stocks for better diversification and long-term growth. But I’m not really sure those reasons hold up any more.

Better diversification? Take a look at the top holdings of your domestic large-cap or index stock fund. You’ll find huge multinationals that do tons of business overseas—Apple, Exxon, General Electric. Investing abroad and at home are close to being the same thing, as we saw during the financial crisis in 2008, when all our developed global markets fell together.

As for growth, we’ve been told to look to the booming emerging markets—only they don’t seem to be emerging much lately. Even as the U.S. stock indexes have been reaching all-time highs, the MSCI emerging markets benchmark has had three consecutive sell-offs in 2012, 2013 and 2014, missing out on a huge recovery. That’s diversification, but not in the direction I want for my SEP-IRA that I’m trying to figure out how to invest. (See “My 6 % Mistake: When You’ve Saved Too Little For Retirement.”)

Some market watchers have pointed out that after two decades, the countries that were once defined as emerging—China, Brazil, Turkey, South Korea—are now in fact mature, middle-income economies. If you’re looking for high-octane growth, you should really be considering “frontier” markets, funds that invest in tiny countries like Nigeria and Qatar.

That’s all well and good. But when it comes to Nigeria, I don’t really feel confident investing in a country where 200 schoolgirls get kidnapped and can’t be found. As for Qatar, it’s awfully exposed to unrest in the Middle East. (Dubai shares just tumbled, triggered by escalating violence in the Iraq.)

Twenty years ago, I was more than game for emerging markets and loved getting the prospectus statements for funds listing then exotic-sounding companies like Telefonas de Mexico and Petrobras. But I just don’t think I have the stomach, or the long time horizon, for it anymore.

My new skittishness around international stocks may be signaling a bigger shift in my investing style from growth to value, the gist of which is this: since you can’t always predict which stocks will grow, the best thing you can do is to focus on price. Quite simply, value investors don’t want to pay more for a stock than it is intrinsically worth. (Growth investors, by contrast, are willing to spend up for what they expect will be larger earnings increases.) By acquiring stocks at a discount to their value, investors hope profit when Wall Street eventually recognizes their worth and avoid overpriced stocks that are doomed to fall.

As Benjamin Graham, the father of value investing, wrote in his 1949 classic, “The Intelligent Investor,” “The habit of relating what is paid to what is being offered is an invaluable trait in an investment.” (Warren Buffett, among many others, consider “The Intelligent Investor” to be the investing bible. ) “For 99 issues out of 100 we could say that at some price they are cheap enough to buy and some other price they would be so dear that they should be sold,” Graham also wrote. And he famously advised that people should buy stocks the way they buy their groceries, not the way they buy their perfume, a lesson in price sensitivity that I immediately understand and agree with.

Looking at the international question through a value vs. growth lens, my choice is seems more clear—at least on one level. If emerging markets are down, now is probably a good time to buy. But the biggest single country exposure in the MSCI Emerging Markets Index is China, at 17%, and it might be on the brink of a major bubble.

It seems a bargain-hunting investing approach isn’t always that much safer, and I’m wondering if it might be worth paying more at times to avoid obvious trouble. Still, I’ve only just discovered my inner value investor. I’m going to keep reading Benjamin Graham and will let you know.

Ruth Davis Konigsberg, a fortysomething journalist and consultant to Arden Asset Management, writes weekly about retirement planning.

MONEY mutual funds

For Big Gains This Year, Fund Investors Go Small. Like Tiny

Stock pickers who manage funds with really small asset bases and make big bets on a tiny group of stocks are shooting the lights out. But for how much longer?

For U.S. mutual fund investors, this is shaping up to be a year when it pays to go small.

Not with small-company stock funds. No, tiny mutual funds with less than $100 million in assets under management are either leading or are among the top three or four best performers in every major U.S. stock category tracked by Morningstar for the year, through June 10.

How come? The outperformance of these tiny funds run by managers that few investors have ever heard of likely reflects the fact that, as passive investing in index and exchange-traded funds becomes increasingly popular, fund managers with small portfolios are swinging for the fences by taking concentrated bets on only a handful of stocks in order to stand out.

When all goes well, that can lead to strong outperformance even after a small fund’s higher-than-average fees; when it does not, those funds are likely to fall among the worst-performers.

At the same time, stock pickers tend to reap the biggest rewards in the later stages of a bull market, when rallies are less broad.

Each of the small funds leading their categories this year have 30 or fewer stocks in their portfolio. The $25 million Biondo Focus fund, for instance, has gained 9.8% for the year with its portfolio of 19 stocks, trailing only two other funds among the 1,743 in the Morningstar large-cap growth category. Its top holdings include a 14% stake in J.P. Morgan Chase , 12% in Pacira Pharmaceuticals , and 10.3% in Gilead Sciences .

By comparison, Fidelity’s $107.5 billion Contrafund, a mainstay of retirement accounts, holds no more than 4.5% in any one of its 298 holdings. The fund is up 3.4% for the year, putting it in the 57th percentile of the large growth category. Over the last three years, however, Contrafund has returned an average of 17.1% a year, while the Biondo fund has gained an average of 13.5% over the same time frame.

“When you are running a concentrated fund, you are taking greater risk opportunity for greater reward. If you pick the right stocks your winners are going to shine,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

Picking only a handful of stocks tends to work better in the U.S. than in the emerging markets or Europe, Rosenbluth added, where a fund manager has to be right on not only a company, but on the performance of countries as well. Internationally, large funds by giants like Fidelity and T. Rowe Price Group Inc are leading the pack in categories ranging from emerging market stocks to European equities.

The managers of small funds, for their part, cite some advantages to their size. Brian Boyle, the lead portfolio manager of the $21 million Valley Forge Fund, whose 19.9% gain for the year leads all other large value funds, said he can be more nimble than the other 1,290 competitors in his category.

He has been able to build up nearly 10% of his portfolio in oil and gas company Birchcliff Energy even when just 5,000 shares of its stock change hands each day on average, he said, a position that a larger fund could not do without becoming a significant owner of the shares. Birchcliff shares are up 91% for the year.

“At some point there could be a constraint in terms of fund size, but we’re nowhere near it,” he said.

MONEY alternative investments

Wise Up About Funds that Claim to Take “Smart” Risks

A new group of funds that claim to outperform the broad market while taking less risk are worth exploring—if you're willing to look under the hood.

Ever since the dot-com crash more than a decade ago, Wall Street and the mutual fund industry have been on a relentless push to plug what they are now calling “smart” beta strategies. These funds promise reasonable returns with lower risk through a variety of techniques.

But pursuing a smart-beta strategy isn’t as simple as just buying a fund with that name and thinking it will outperform conventional index funds. There’s always a trade-off in costs, risk and return, so you need to dig much deeper to get beyond simplistic marketing pitches.

For example, let’s say you were seeking an alternative strategy to traditional S&P 500 index funds that weight the holdings in their portfolios by market valuation.

In such traditional “cap-weighted” S&P 500 funds, the top holdings would be Apple at about 3% of the portfolio, followed by ExxonMobil at 2.6% and Microsoft at just under 2%. Every other stock in the portfolio would represent a slightly lower percentage of the total holdings.

The idea behind cap-weighting is that the biggest U.S. stocks by popularity ought to represent the largest portions of a broad-market portfolio. This is what economist John Maynard Keynes called a “beauty contest,” with investors bidding up the prices of the most glamorous stocks. The downside is that these companies may be overpriced and may not have as much room to grow as other, bargain-priced stocks.

One alternative in the smart beta fund category is a so-called equal-weighted stock index fund such as the Guggenheim S&P 500 Equal-weight ETF , which holds the same stocks as the S&P Index, only in equal proportions. This design somewhat side-steps the overpricing issue because it’s less exposed to beauty contestants, especially when they falter a bit.

To date, both the long- and short-term performance of the equal-weighted strategy has been better than cap-weighted index funds. The Guggenheim fund has beaten the S&P 500 index over the past three, five and 10 years. With an annualized return of 9.7% over the past decade through June 6, it’s topped the S&P index by more than two percentage points over that period. But it costs 0.40% in annual expenses, compared with 0.09% for the SPDR S&P 500 Index ETF.

Once you start to ignore the beauty pageant for stocks, is there an even “smarter beta” strategy?

What if you picked the best stocks based on a combination of value, sales, cash flow and dividends? You might find even more bargains in this pool of companies. They’d have strong fundamentals and might be more consistently profitable over time.

One leading “fundamentally weighted” portfolio, which also resides under the smart beta umbrella, is the PowerShares FTSE RAFI US 1000 ETF , which also has outperformed the S&P 500 by about two percentage points over the past five years with an annualized return of 20 percent through June 6. It costs 0.39% annually for management expenses.

The PowerShares fund owns some of the most-popular S&P Index stocks like Exxon Mobil, Chevron and AT&T , only in much different proportions relative to the cap-weighted indexes. The RAFI approach focuses more on cash, dividends and finding undervalued companies, so it’s not necessarily looking for the most-popular stocks.

Although looking at the rear-view mirror for index-beating returns seems to make equal- and fundamental-weighted strategies appear promising long term, you also have to look at internal expenses to see which strategy might have the edge.

Turnover, or the percentage of the portfolio that’s bought and sold in a year, is worth gauging in both funds. Generally, the higher the turnover, the more costly the fund is to run. That eats into your total return. The PowerShares fund has the advantage here with an annual turnover of 13%, compared to 37% for the Guggenheim fund.

Over the long term, “fundamentally weighted smart beta strategies are likely to outperform the equal weighted approach,” note Engin Kose and Max Moroz with Research Affiliates, a financial research company based in Newport Beach, California, which largely developed the concept of fundamental weighting and is behind RAFI-named indexes.

But just considering costs doesn’t end the debate on equal- and fundamentally weighted funds. While they may be higher-performing than most U.S. stock index funds over time, they are not immune from downturns. Both lost more than the S&P 500 in 2008 and 2011.

While it may be difficult to predict how these funds will perform in a flat economy or a sell-off, they are worth considering to replace your core stock holdings, and may be the wisest choices among the smarter strategies.

MONEY Portfolios

Alex, I’ll Take “How to Invest Like a Jeopardy Champ” for $1000

140610_INV_Jeopardy_1
Host of Jeopardy! Alex Trebek and contestant Arthur Chu. courtesy of Jeopardy

Controversial Jeopardy champion Arthur Chu talks with MONEY about risk-taking, his long-term goals, and why he isn't in the market for a shiny convertible.

Earlier this year, Arthur Chu won a staggering 11 games on Jeopardy, nearly $300,000 in prize money, and the unofficial title of “Jeopardy Villain.”

Chu upset some gameshow purists with his counter-intuitive tactics. For instance, he relied on game theory to outmatch his opponents. Chu would often skip around from category to category and select the most valuable answers first. Fans who were used to contestants staying in one category, and starting with the least valuable answers, chafed at his approach. (Although Chu is hardly Jeopardy’s first unconventional player.)

A few months after his epic run, Chu had to figure out what to do with his winnings, and how to adjust to life with a lot more money in the bank.

The 30-year-old voice-over artist and actor lives in Broadview Heights, Ohio, and recently spoke with MONEY.

(The interview has been edited.)

Viewers seemed to view you as a risky player, but you’ve maintained that your strategy was risk-averse. How so?

For some reason, probably because Jeopardy consistently refers to its points as “dollars,” people don’t get the most fundamental rule of how Jeopardy works — the points you earn in the game are NOT dollars. They only turn into money if you win the game, if after Final Jeopardy you’re in first place. If you aren’t in first place, all your points disappear, your total is completely erased and you either get the 2nd-place $2,000 or 3rd-place $1,000 consolation prize and go home.

The expected value of winning the game versus losing is immense. Not one single dollar in your stack is worth anything if you lose. And yet people do irrational stuff all the time like make bets that ensure they’ll still “have something” if they lose the bet, even though if you lose the game “having something” and “having $0″ are completely equivalent — you get the same consolation prize either way.

So imagine if you had some bizarre contract where if your investment portfolio hit a certain value by a certain time limit, you get to keep the money. But if it’s below that value all the money is taken away. Do you see how this would be different from normal investing? How “low-risk” moves would actually be very high-risk moves — the “safer” your portfolio is, the higher the risk that you won’t hit your target and win the game, and all your money will vanish?

Speaking of risk, how do you view risk in your own portfolio?

When all I had was a small amount of savings I was invested conservatively to make sure that our total funds wouldn’t dip too low in case we needed them — specifically the Vanguard LifeStrategy Conservative Growth Fund (VSCGX).

Now that I have a much bigger stack I’m sitting on and the capacity to absorb more downside risk I have it all invested aggressively in Vanguard’s Target Date 2050 Retirement Fund (VFIFX.) I’m trying to keep everything as automated as possible so that managing money can be one less drain on my thoughts and energy among all the other stuff I have to do.

What’s your long-term investing strategy? Do you own actively managed funds?

As long as I’ve been into investing I’ve been an indexer. I’ve absorbed the gospel of A Random Walk Down Wall Street, I follow the Bogleheads forum, I’m invested in Vanguard, all of that stuff.

I’ve yet to see a compelling, rational argument that says you come out ahead with active investing — at least not without a lot more research and a lot more savvy that I really want to put into it. (You have to be able, as a non-financial professional yourself, to identify the managers you trust to give you above-market returns — and not just above-market returns but returns that are enough above market to justify the cut they take. I’ve yet to see a reliable method for doing this.)

What goals will your winnings allow you to achieve?

It’s not really buying stuff that matters most to me — the single thing I value most that’s most irreplaceable is my time. A nine-to-five job, while it comes with a lot of perks and a lot of security, takes the lion’s share of the hours in the day away from me and puts them toward something I’d rather not be doing. To be able to live a life basically like the one I have now but to have that time freed up — that’s worth more than any car or any cruise.

What does all of this money buy you?

The main thing it buys is a feeling of peace. I have no intention of quitting my job in the near future but just knowing that you don’t need a job is profoundly freeing.

Knowing that I could buy almost anything I wanted if I really wanted to is profoundly freeing — and, paradoxically, having this knowledge means I no longer think about things I want but can’t have nearly as much. When the thing that you’d be trading off for the lust-inspiring luxury is tangible — when I know that I’d be trading, say, six months of not having to work for a shiny new convertible — it puts things in perspective and helps push away the need to lust over such things.

MONEY alternative assets

Why You Don’t Need "Alternative" Funds

Mutual funds that mimic hedge funds are Wall Street's hot new thing. Too bad they hedge away your best shot at returns.

So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they’ll go “short”—that is, bet on stocks or market indexes to go down.

Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren’t all that impressive compared with what you can make just owning an S&P 500 index fund.

And mutual funds that mimic these strategies haven’t exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That’s about a tenth of the gains of the broad market during that time.

Financial sophisticates will call that an unfair comparison. Fine. But there’s a reason besides performance to give clever-sounding hedge-like strategies a pass.

Consider this deal: I’ll sell you this very nice antique vase. And I’ll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.

You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it’s a nice vase. And if there’s a chance about the fairy…

When you buy a regular stock fund, you’re buying the vase. Most of what you get is the market’s return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn’t all that skilled, you can still do okay so long as the market rises.

Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.

The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and “shorting” Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager’s investment-picking skill.

Skilled managers aren’t as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don’t beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market’s average, minus fees. Though some managers do outperform over time, it’s hard to tell which ones were lucky and which ones have a skill that will persist over time.

It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.

MONEY financial advisers

The Investing Client Who Wouldn’t Let Me Invest

What do you do when someone hires you to invest her portfolio — and then won't let you invest her portfolio? For starters, you send her 80 reports over 13 months.

My client finally spoke the words I thought I would never hear: “I would really like to get those trades in gear,” she said.

It had been 13 months since she opened her account with my investment advisory firm. In all that time, she would not agree to any major changes in her portfolio. Faced with big decisions, she wanted to discuss them. She couldn’t focus on them. She had to research them. She put us off. No trades.

Essentially, she was paying us fees for a job she wouldn’t let us do.

Was it an issue of control? I didn’t think so. A successful architect, she came to us because, she said, her portfolio was getting too big to handle. She wanted to hand it off.

She’d done pretty well investing on her own. Her portfolio was reasonably diversified. But when we asked her why she chose this or why she held that, it became clear she saw patterns that weren’t there.

If a fund performed well for five years, then fell off the charts for the next three years, she believed it would do well again, and she would wait—even if that meant years of underperformance. If her fund was a winner, no other fund should be considered—not even ones that had less risk, charged lower expenses, or performed better. Everything she held, she loved.

No amount of analytics, discussion…nothing would change that. Of course, I didn’t figure this out, and I worked hard to change her mind. I pumped out charts and sent copies of articles. We’d meet, exchange emails, and talk time and again about portfolio constructions. I’m not exaggerating: I sent her more than 80 reports as part of my effort.

I should have seen what was going on: She was uncomfortable. She was wary about making changes—about going headlong into new asset classes or new funds. She handled complex building projects every day, down to the nuts and bolts. But she kept saying she couldn’t get her mind around all these investing ideas that were so new to her. She was in a bit over her head, and she didn’t like that at all.

I eventually told her that was what investing is like. If you have a reasonably diversified portfolio, something will always be your favorite and something will always be the dog you wish would wander off. She just had to get used to being uncomfortable with the market—but comfortable with me as I steered her through it.

One day, she decided she was. And then she said we could make the trades I had wanted to make for a year.

Behavioral economists would see my client’s reluctance to trade as an extreme example of projecting the past into the future. That’s one of the ways that the intuitive human mind works. Another intuitive leap people make is to think that if they’ve been right once, they will be right again. That’s why clients so often ask why they should have to sell a winner. It’s their intuition. Intuition, though, isn’t a great tool for managing portfolios.

In all this, I gained a healthy respect for the mental gymnastics it took for this new client to become a good client. The ushering-in process can be hard. I should have paid more attention to what she was going through to reach me, rather than to what I was doing to reach her.

—————————————-

Harriet J. Brackey, CFP, is the co-chief investment officer of KR Financial Services, a South Florida registered investment advisory firm that manages more than $330 million. She does financial planning and manages clients’ portfolios. Previously, she was an award-winning journalist covering Wall Street, with stints at Business Week, USA Today, The Miami Herald and Nightly Business Report.

MONEY Investing

Emerging Markets that Merit a Closer Look

Pedestrians walk past a Citibank branch in Mumbai Dhiraj Singh / Bloomberg / Getty Images

Emerging economies have tumbled in unison, yet some have far better prospects than others

The best time to buy something is when it’s on sale.

The place to look for stock bargains may finally be among developing economies, where share prices collectively are down 17% from their recent spring 2011 peak and stocks are trading at an average price/earnings ratio of 10.7 — a 40% discount to shares of developed nations.

Notes Jeff Shen, head of emerging markets at BlackRock: “That’s about the widest spread in more than 15 years.”

True, with risks rising abroad, there are reasons developing-nation stocks are so cheap. China’s growth is slowing, Brazil faces deficits, Russia just annexed Crimea — the list goes on. And as the Federal Reserve tapers bond purchases, global credit is shrinking, which hurts smaller countries dependent on foreign investment.

For those with a discerning eye, however, the recent selloff could spell opportunity.

“Emerging-market nations are no longer monolithic, and some are in pretty good shape,” says T. Rowe Price emerging-markets specialist Todd Henry.

He expects these healthier economies to spur the benchmark MSCI Emerging Markets Index to deliver 11.5% earnings growth in 2014 — more than two percentage points higher than the forecast for the S&P 500 index.

The following strategy will help you identify the most promising areas, while limiting your risks.

Look under the hood

Three trends seem likely to move emerging markets this year:

Asia will deliver solid growth. As China shifts from an economy propelled by exports to one driven by domestic consumption, its expansion is slowing. Yet concerns about stagnation seem overblown, given forecasts for a 7.5% rise in GDP in 2014.

“That’s more than twice as fast as developed nations,” says Justin Leverenz, manager of Oppenheimer Developing Markets, which has a 19% stake in China. Even if China stumbles, Taiwan and South Korea look strong.

“These countries have big current-account surpluses, as well as global trade that isn’t dependent on China,” says Arjun Jayaraman, co-manager of Causeway Emerging Markets.

Scary markets will stay scary. Case in point: Russia, where stocks have fallen 17% this year. Even before the Crimean crisis, Russia’s economy was in a slump, partly from political uncertainty.

“Disruption goes with the emerging-market territory,” says Craig Shaw, co-lead manager of Harding Loevner Emerging Markets. Shaw is sticking with a 6% stake in Russia.

Emerging markets do often rebound sharply before their economies recover. Over the past year, for example, stock prices in Greece, which was demoted to emerging-market status last fall, have jumped 52%, even though its debt problems aren’t resolved. Whether those gains are sustainable if there’s no progress soon is another question.

Think smaller for bigger gains. The least-developed emerging economies — so-called frontier markets, such as Ghana, Estonia, and Vietnam — tend to perform differently from more established markets.

Over the past year, for instance, the MSCI Frontier Index has risen 22.6%. The challenge: It can be tough to get in on the action since these shares tend to be thinly traded and most emerging-markets funds hold only a small stake.

Fine tune with two funds

Given the risks, “most people should put no more than 5% of their overall portfolio into emerging markets,” says Chicago financial planner Mary Deshong-Kinkelaar.

Start with a diversified fund that gives you exposure to all these countries, but maintains a bigger stake in more stable areas. For instance, Vanguard Emerging Markets Stock Index , recommended on our MONEY 50 list, has 23% of its assets in China, 15% in Taiwan, and 5.2% in Russia. T. Rowe Price Emerging Markets , also on the MONEY 50, holds similar country stakes.

Then add a second fund, tilting toward added safety or a riskier bet, as you prefer. Cautious investors might gravitate to Matthews Asian Growth & Income , which holds dividend-paying stocks from developed and emerging Asian countries.

Looking for more pop? Add a frontier-market fund, such as Guggenheim Frontier ETF . Just be sure to fasten your seat belt for the inevitably bumpy ride.

MONEY

Mutual Funds Gone Down the Drain

Forty-one percent of U.S. mutual funds operating 10 years ago, closed before 2014.

Your mutual fund does worse when its close to extinction. Here's what to do about it.

Of all traditional U.S. mutual funds operating a decade ago, four in 10 shut down before 2014, reports Morningstar.

Why care? Even though you can cash out (or get shares in a fund absorbing the loser), costs rise and performance falls as the end nears, says Daniel Kern, president of investing firm Advisor Partners, who has studied closures.

Here’s how not to get swept away in the failures.

Stopping your losses

Seek high marks. Eight in 10 funds given five stars by Morningstar in 2002 lived to 2012; only 39% of one-star funds did, according to a study Kern co-wrote. Stewardship grades, gauging how shareholders are treated, count too: A and B funds outlast low-ranked ones, says Morningstar’s Laura Lutton.

Don’t think small. Bigger funds aren’t always better, but those that stay small or shrink too much have high failure rates. Be wary of portfolios with assets well under $250 million, says Kern’s collaborator Tim McCarthy, author of The Safe Investor.

Exit early. If you think a fund will close, sell. Funds lose an average of 3.6% in their final 18 months, Vanguard has found. Has your fund already merged into another offering? Be picky, advises San Diego planner Leonard Wright, and sell the new one if you wouldn’t have bought it otherwise.

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