Emerging markets: Too much fun?

• Emerging markets up 1.95%25 in the 12 months ended in June
• Top emerging market year to date%3A Philippines%2C up 4.46%25
• Worst emerging market year to date%3A Brazil%2C down 22.23%25

This is the point in the year when your friend Fred will come back from some exotic locale and tell you, at great length, how he trained an orphaned wallaby to play the flute. You hate Fred, because the only time you went to an exotic location, you got something that made your dermatologist give a low whistle and slowly back out the door.

Investors can, in fact, have very rewarding experiences sending their investments to exotic locations, such as China and Brazil — called "emerging markets," because they're vibrant, up-and-coming economies. But they may no longer be the growth giants they used to be — and they might not be as helpful to your portfolio as they once were.

The argument for emerging markets has always been simple: It's where the growth is. While the U.S. would be overjoyed for 3% growth in gross domestic product, China routinely clocks in at north of 7%, and Brazil, while more mercurial, often chalks up 4% or higher GDP growth. Russia's GDP growth is whatever Vladimir Putin says it is.

High economic growth can often result in high stock returns. The MSCI Emerging Markets index has gained 253% the past decade, vs. 109% for the Standard & Poor's 500 stock index with dividends reinvested. MSCI's Europe, Australasia and Far East Index — basically, the developed world index — has gained 125% the same period.

But along with your gains (or losses), you're adding a heaping helping of volatility, as investors found out recently. The average emerging markets fund has fallen 6.2% this year, for four reasons: Brazil (-22.2%), Russia (-12.0%), India (-15.0%) and China (-10.6%). These four countries, called the BRIC countries, were once the powerhouses of the emerging markets.

Losses are not particularly a reason to avoid emerging markets. These are, after all, stocks, and stocks are volatile. But emerging markets are inherently more volatile than stocks of developed nations, because their economies tend to be more specialized and their politics more unsettled. Markets love predictability, and countries such as Brazil are often unpredictable.

But adding emerging markets to your portfolio may not be as traumatic as it seems, and may, in fact, be a useful way diversify. Markets in Thailand and Argentina are not as closely correlated to U.S. and world markets. When your emerging markets fund is having an attack of the fantods, your U.S. fund could be rising, and vice-versa. Over the past decade, about 65% of emerging markets returns can be attributed to returns in the U.S. In contrast, about 85% of EAFE returns can be traced to U.S. returns.

Furthermore, emerging markets are cheap, relative to developed markets. The price-to-earnings ratio of the MSCI Emerging Markets index stood at about 11 at the end of the second quarter, while the S&P 500's PE was 15.7. Some of that cheapness is because of political risk; others suggest that companies in emerging markets are less efficient and therefore, cheaper.

Another reason emerging markets may be cheap: It's best to look at emerging markets when growth is accelerating, not decelerating — which it's currently doing, according to Rex Macey, chief investment officer for Wilmington Trust. "I still think that growth rates in emerging markets are stronger than those in developed markets, but they are going through a period of weakness," Macey says.

In China, for example, the key purchasing managers' index rose to 50.3 in July, just a whisker above its previous 50.1 level in June. Readings below 50 indicate contraction. China's official GDP growth is 7.6%, but analysts are skeptical about how accurate the Chinese government's figure is.

China has a longer-term problem, which is that its workers are getting older, and are demanding higher pay. "Outsourcing to China is not as attractive as it was," Macey says. While the population won't get old overnight, eventually, the country will have to address one repercussion of its one-child policy: a rising percentage of older people who need care. China is now focusing on internal consumer growth, rather than export growth, but that's a big shift in a big country, and could take a long time.

What's an investor to do? The average person can live a long and happy life without the generally recommended 5% position in emerging markets, especially if you own a broadly diversified international or global fund. Vanguard Total International Stock Index had 16% of its assets in emerging markets at the end of June, according to Morningstar. The American Funds EuroPacific Growth Fund, the nation's largest international fund, had about 18% of its assets in emerging markets.

If you're more adventuresome, and want to test the emerging markets waters, a fund that looks for cheap, beaten-down stocks is probably best at a time when the markets are depressed. Templeton Developing Markets (ticker: TEDMX) is a longtime sturdy performer, but an expensive choice: The A shares carry a 5.75% maximum sales charge and a 1.7% ongoing expense ratio.

For the cost-conscious — and that should be everyone — there's Vanguard Emerging Markets Stock Index (VEIEX), which tracks the FTSE Emerging Markets Index and charges no sales charge. Expenses: 0.33% a year.

At this juncture, emerging markets are probably best for those who are willing to take reasonably large risks. It's not as heart-stopping as, say, being chased by a tank through the jungle. But if you buy cheap and mind your investment, it could be more rewarding.