Markets around the world continued their downward spiral in the second quarter. Company after company missed earnings targets. Big tech names were dismal investments. So it was no surprise that almost half of the 500 biggest offshore funds in the world lost money compared with the same period a year ago.
But count on markets to surprise. An unexpected bright spot appeared right where the downturn started last year: U.S. small caps. Another strong sector was biotechnology. Fourteen of the top 25 funds in BusinessWeek's quarterly Offshore Fund Scoreboard focus on U.S. companies that generally have market capitalizations of less than $5 billion. Two of the top 25 were global biotech funds. The survey tracks the performance in dollar terms of the 500 biggest equity mutual funds for retail investors who live outside the U.S., based on data from Standard & Poor's Micropal, available at www.micropal.com.
The small-cap group boasted returns ranging from the Schroder ISF U.S. Small Cos. A Fund's respectable 13.41% to the Fleming FF U.S.A. Discovery Fund's 27.79%. The leader of the offshore pack was the Luxembourg-registered Dexia Eq L Biotechnology C Fund, which managed a remarkable 37.6% gain.
Offshore funds don't file reports with the U.S. Securities & Exchange Commission and aren't marketed in the U.S. But their performance reflects decisions by U.S. and international investment strategists, and many U.S. institutional and retail investors put money into them via offshore accounts (and indirectly through U.S. funds that invest in them).
That U.S. small companies did so well is all the more noteworthy because 11 of the 25 worst performers were euro zone small-cap funds. Why did U.S. funds outstrip their European counterparts? One factor is an expectation of a U.S. rebound in the fourth quarter vs. a waning outlook in Europe. Another is the broader range of U.S. small companies for fund managers to mine. "In the U.S., you have companies that are operating in pockets that are immune to the general economic situation," says Susan Hirsch, portfolio manager of the Prumerica U.S. Aggressive Growth A Fund, which ranked 11th last quarter. "You probably don't have the same universe in Europe."
STAR-SPOTTING. Adam Smears, an analyst for the $598 million Fidelity American Growth Fund, has another theory: "The real attraction of U.S. small caps is that they are so under-researched." That means managers who do their homework can spot hot niche players--especially those with proven business models--even in beaten-down sectors. "I've got some chip companies that have quadrupled in value," says Will Bales, portfolio manager for the $129 million Janus World U.S.A. Venture A1 Fund. One is Microtune Inc., a maker of chips for the next generation of television set-top boxes. "Even though it's a tech company, people still want their cable TV," he says. "And the valuations are low."
Those looking to invest outside the U.S. should consider the Far East. Not Japan, of course, where the depressed economy has little to offer. But several funds investing in China and South Korea have had remarkably good quarters. The $140 million HSBC GIF Chinese Equity Fund, for example, invests in B shares (mainland companies restricted to foreign investors and foreign currency holders) and H shares (mainland companies listed in Hong Kong, also known as red chips). It earned a very strong 28.57% return in the second quarter.
Lead manager Richard Wong says the key to the fund's success was "aggressive shuffling between the different groups of mainland plays to take advantage of huge arbitrage opportunities." Late last year, he started loading up on B shares in anticipation of the government relaxing rules restricting their ownership to foreigners. At its height, the fund held a 25% weighting in B shares when they were trading at a 75% discount to their A-share counterparts, which only Chinese nationals can own. Wong sold most of those shares in the second quarter, when the differential narrowed to 40%. He has since plowed the profits into H shares, trading at an 80% discount to A shares.
Investors may be deserting telecom stocks elsewhere, but Wong says he swears by them. His two biggest holdings are China Mobile Communications Corp. and China Unicom Ltd. Both are listed in Hong Kong. China already has 112 million mobile subscribers, and it looks like it may have 150 million by yearend. What's more, domestic providers will be able to count on protection from foreign competition for two years after China's admission into the World Trade Organization.
In South Korea, the star (No. 6) was the $97 million JF Korea Fund. Its co- manager, Edward Pulling, attributes the success to "dogged research," meaning: "We are in an enviable position of not being surprised by a downturn in operating conditions." Like his peers in the U.S., Pulling found the biggest growth opportunities were outside the big-cap sector. One of his favorite mid-caps was Kookmin Credit Card Co., which will benefit from legislative changes compelling vendors to accept credit cards to improve sales-tax collection. Among the big caps, he likes Daewoo Shipbuilding, which has undergone massive restructuring.
What about the future? Investors are pulling away from emerging-market economies such as Argentina, Brazil, and Turkey, which are in crisis. The euro zone's rigid economy will revive less quickly than the U.S.'s once the current downturn ends. So for most portfolio managers, there is a flight to quality, which means U.S.-oriented funds will continue to dominate. By David Fairlamb in Frankfurt, with Frederik Balfour in Hong Kong and Julia Lichtblau in New York