Emerging market funds are powered by tech stocks

If you notice that your car is going 115 miles on the highway, instead of the usual 53, you might be tempted to look under the hood to see if someone dropped a Maserati engine in while you weren’t looking. And if your client’s emerging market fund is suddenly returning 15 percentage points more than its index, you might want to peek under the hood of the fund, too.

In most cases, you’ll find lots of Chinese internet companies. That might not be a bad thing — they have done spectacularly well over the past 12 months. But your clients could someday regret the risks that a souped-up emerging market fund poses.

Emerging market funds have torn up the track in the past 12 months. The MSCI Emerging Markets Index, the benchmark for many emerging market funds, zoomed up 31.97% over the past 12 months. The Standard & Poor’s 500, in contrast, has cruised at a slightly lower 19.6% pace.

Many investors and advisers view emerging markets as a highway to the commodities markets. Countries like Brazil and Russia, for example, feed the world’s appetite for oil, timber and iron ore. While those industries are still important — materials account for 7.46% of the MSCI index, and energy is another 7.2% — emerging market funds are also a six-lane highway to the tech sector, which accounts for 27.38% of the MSCI index. In contrast, tech makes up just 21.57% of the S&P 500.

Not surprisingly, some of the emerging markets funds with the hottest records also have high-octane weightings in both technology and China. The $1.7 billion Templeton Developing Markets fund (TEDMX), for example, has a 35.9% stake in technology and a 23.7% position in China, according to Morningstar Inc. Taiwan Semiconductor, Alibaba Group and Tencent are all in the fund’s top 10 holdings. Columbia Emerging Markets (UMEMX), a $1.6 billion fund, has 34.15% of its portfolio in technology and 28.81% in China.

Emerging market funds and ETFs with “technology” or “internet” in the name are often stuffed with Chinese technology stocks. EMQQ Emerging Markets Internet and Ecommerce ETF (EMQQ) has 7.8% of its portfolio in Alibaba and 6.96% in Tencent.

All of this makes a great deal of sense. People in emerging markets are gleeful consumers of technology. It’s not uncommon to see goatherds in Tanzania chatting on their cellphones or Kenyan shoppers making purchases with their phones. Online marketplaces, such as Alibaba, are enormously popular around the world, and internet providers, such as Tencent Holdings, have been running hot, too. Alibaba gained 97% last year; Tencent soared 115%. Both companies have price-to-earnings ratios north of 50.

Furthermore, most people who invest in emerging markets do so for growth, said Paul Espinosa, portfolio co-manager of Seafarer Overseas Growth and Income Fund. Both technology and China are reasonable bets on growth.

“The question is whether people are aware of the sector concentration and the valuation that the sector trades at,” he said.

Advisers should be aware of several potential problems from tech- and China-heavy investment vehicles. The first is that both China and tech tend to be volatile. And while they have produced outsized returns, investors should be prepared for outsized spinouts in top-performing emerging markets funds that look for stocks with rapid earnings growth.

“A downturn in Chinese tech stocks could be quite painful,” said William Samuel Rocco, a senior fund analyst for Morningstar. “The most aggressive funds might not be the best long-term investment vehicle, as many people learned the hard way in the early 2000s.”

Another problem could be that your clients already have plenty of tech stocks in their U.S. portfolios. The average large-company growth fund has about 31% of its assets in tech, according to Morningstar. Large-company international funds have an average 17% in tech. The top three holdings of the $31.7 billion Vanguard Growth Index Fund Investor Shares (VIGRX) are Tencent Holdings, Alibaba and Baidu, China’s largest search-engine company.

One alternative could be to look for an emerging markets fund with lower tech and China holdings. The problem is that many won’t have the racy returns that more tech-laden funds can offer.

A few alternatives: BlackRock Emerging Markets Equity Strategies (BEFKX), up 30.50% in the past 12 months. It has 20.73% in China, but 9.26% in technology. Brandes Emerging Markets Value (BEMIX) has 6.49% in technology and 7.48% in China. It’s up 20.72% over the past 12 months. Rebalancing a client’s emerging markets position within the portfolio could also reduce some risk.

At the moment, both tech and emerging markets seem to be doing fine. “At some point — I don’t think it’s now — that reverses,” said Todd Rosenbluth, senior director of mutual fund and ETF research at CFRA.

For those who invest in actively managed funds, the danger is that you may not know just how heavily an emerging market fund is invested in tech and China until it’s too late.

“It’s not a problem until it is,” Mr. Rosenbluth said.

(More: International ETFs are ready for takeoff)