Sometimes an investment idea is so strong, it bears repeating.

#-ad_banner-#In late February, my colleague Michael Vodicka implored readers to give emerging market stocks a fresh look. Though he cautioned that these struggling markets may not have yet hit bottom, he added that “the MSCI Emerging Markets Index is trading at just 11 times earnings. Not only is that a massive 40% discount to the MSCI World Index, it’s the widest gap since the financial crisis of 2008 and a 10-year low.” As a potential catalyst, Michael noted that the recent price rebound for many commodities should help bolster a number of emerging market economies.

But there’s another, even more powerful reason to own emerging markets, which merely strengthens the investment case: They reduce risk. That may seem counterintuitive, so let me explain.

Risk-Adjusted Returns
Back in November, S&P Capital’s Global Equity Strategist Alec Young took a look at historical market returns to identify how domestic and foreign stocks performed each year. If these two asset classes merely mirrored each other, then there would be no need to own foreign stocks. But as we saw in 2013, U.S. stocks soared, while emerging markets slumped.

The advantage to owning asset classes that have divergent returns is that a broad-based portfolio can smooth out volatility. Said another way, such a mixed portfolio can reduce risk by delivering non-correlated returns, delivering higher risk-adjusted returns. Young’s conclusion: “the ‘sweet spot’ on the efficient frontier, or the allocation that produced the highest risk adjusted returns was a 70% domestic allocation coupled with a 30% foreign weighting.”

Not only did such a portfolio beat a basket of U.S. only stocks over the past 40 years, but “the 70% to 30% U.S.-foreign allocation also produced a higher risk adjusted return than the 19 other possible domestic-foreign allocations we analyzed,” he concludes.

Of course, foreign stocks comprise everything from multi-billion dollar Swiss drug giants to small-cap retailers in Indonesia. Simply focusing on blue-chip stocks in well-developed economies in Europe are not going to provide much diversification with U.S. stocks. For example, the Vanguard FTSE European ETF (NYSE: VGK) has traded in lockstep with the S&P 500 over the past year, with both the Europe ETF and the U.S. index delivering a roughly 20% gain.

Of course any investment in emerging markets over the past year may have seemed mistaken. Indeed, warning signs emerged back in late 2012, led by the plunge in commodity prices that would have clued investors in to a timely exit. But S&P’s Young isn’t talking about near-term results, simply because we really don’t know how foreign stocks will perform in any given year.

Make no mistake. You don’t need to absorb massive risk by owning emerging-market stocks and funds — if you choose the right assets to own. Young recommends shares of the iShares Core MSCI Emerging Market ETF (NYSE: IEMG), which owns stable companies such as Samsung (OTC: SSNLF) and China Mobile (NYSE: CHL).

Right now, that’s about as far as many U.S. investors want to go with their foreign exposure. As recently noted in The Wall Street Journal, “after years of distortion from crisis and crisis response, the world is rebalancing. For emerging markets, the path will surely be bumpy.”

Yet that article also notes that emerging market economies tend to carry a lot less debt than the U.S. and European economies. And many of the most troubled emerging markets are still far healthier than they were when prior economic crises spread across the globe.

To be sure, emerging markets don’t outperform developed markets over the long run, as this recent article in The Wall Street Journal notes. “But emerging markets have tended to do stunningly well over shorter periods when investors neglected or rejected them,” the authors add.

As an example, emerging markets slumped badly when the dot-com bubble imploded here in the U.S.

“By 2001, assets at emerging-market funds had dwindled 20% from 1996, and many investors gave up; in 2001 alone, they pulled out 6% of their money … Naturally, between 2001 and 2010, emerging markets returned an average of 15.9% annually, while U.S. stocks grew at an annualized average of 1.4%.” The key takeaway: The best time to focus on emerging markets is when others have shifted assets elsewhere.

A Top-Performing Mutual Fund
In addition to the exchange-traded funds (ETF) cited by S&P’s Young, investors should also consider the Harbor International Investor Fund (Nasdaq: HIINX). “This fund has generated exceptional performance by ignoring short-term volatility and focusing on the long term,” according to Morningstar, which gives it a “gold” rating.

The approach used by this mutual fund’s portfolio managers speaks for itself: “Management looks for long-term catalysts that may not materialize for three to five years or more, opening it up to a broad range of opportunities. Rather than spending time trying to guess a company’s near-term earnings, the team looks for structural shifts that will affect industry pricing power and competitive advantages, which drive profits over the longer run,” writes Morningstar’s Kevin McDevitt. The approach has yielded a 21% annualized gain over the past five years, and equally important, the key holdings in the portfolio aren’t tightly-correlated with U.S. stocks.

Risks to Consider: If you have a six or 12-month time horizon, then you should never invest in emerging markets. They can radically underperform the developed markets in any given year, as was the case in 2013, and could still be the case in coming quarters.

Action to Take –> If you have a longer-term time horizon, then history suggests that you’re bound to generate strong returns form emerging markets, simply because we have been through a period of underperformance. It’s an asset class that zooms into and out of favor, and right now, the current disdain for them, along with their non-correlation with U.S. stocks, gives them the potential for a solid rebound.

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