Loud Cheers Abroad For Funds

Returns are tasty. Can the party go on?

After the tumultuous end of 1997, investors prayed for an easier ride in 1998. So far, they've gotten their wish. A rising tide of global liquidity buoyed most offshore equity funds in the first quarter. Nowhere was the flood of money more welcome than in Asia, especially among the battered ranks of Korean funds. In a dramatic reversal from last quarter, the Korean stock market surged 58% in U.S. dollar terms during the three months ended Mar. 31, with nearly half of the gain coming from the won's appreciation. Four of the top 10 funds in BUSINESS WEEK's quarterly Offshore Fund Scoreboard are Korea funds, with three-month returns ranging from 34% to 60%.

Korean funds were not the only big gainers. The first quarter was unusually kind to most of the 500 offshore equity funds we follow. More than 90% posted increases for the period. But while Korea dominated this quarter's Scoreboard, most of Asia remains on the verge of recession, and Asian stock markets continue to be dominated by troubled bank and property stocks. Many fund managers now worry that the recent rebound in markets and funds may herald a false dawn for the region. The pros are moving money out of Asia and into Europe, where markets have been surging as much of the Continent prepares for the launch of the euro on Jan. 1.

RECORD HIGHS. Low inflation and an acceleration of corporate restructuring also bode well for European equities. Although price-earnings ratios in the U.S. and Europe are around all-time highs--25 and 22, respectively--Europe offers greater growth opportunities. Indeed, U.S. analysts have been lowering earnings projections even as European analysts have raised theirs, observes Nick Sargen, global markets strategist for J.P. Morgan & Co.'s private client group. "Positive earnings revisions and increased structural changes in European industry will result in more favorable earnings surprises in Europe," he says. As a result, Sargen suggests trimming your U.S. holdings by about 5% and increasing your European exposure by the same amount.

Fidelity Investments is also bullish on Europe. The giant fund manager is reducing its emerging-markets holdings, especially in Asia, in favor of Europe. "People underestimate the severity of the coming recession in Asia," worries Keith R. Ferguson, regional investment director for Fidelity Investments Management Hong Kong Ltd. Anyone remaining in Asia should take a long-term view, Ferguson advises, and be prepared for some gut-wrenching stock market moves.

If you're investing in offshore equity funds, you should have little problem putting together the kind of asset reallocations Sargen and Ferguson suggest. Offshore funds are mutual funds that are based in tax havens, such as the Cayman or Channel Islands. They are marketed outside the U.S. and generally not sold to American investors. Using data provided by Standard & Poor's Micropal (like BUSINESS WEEK, a unit of The McGraw-Hill Companies), we track the world's 500 largest offshore equity funds. The results allow you to allocate assets efficiently among a range of funds investing globally as well as in specific countries or industry sectors. You can find historical data on the 500 funds, complete with phone and fax numbers, in the Nov. 10, 1997, issue of BUSINESS WEEK's international edition, or at www.businessweek.com.

BAD PAPER. In addition to the beaten-down East Asian emerging economies, one market many managers are shunning is Japan, where political paralysis and a battered economy make for a gloomy outlook. Banks admit to $600 billion in bad loans, but most experts figure that number is understated. Standard & Poor's reckons the real figure is closer to $760 billion, and no one knows how bad a hit the banks will take on their Asian loan portfolios, which are stuffed with Indonesian, Thai, and Korean paper. Domestic bankruptcies surged 28% in the first quarter, only adding to the banks' credit-quality woes.

Political dithering means that Japan isn't likely to see the sort of shakeup it needs to get the economy moving again soon. Government attempts to boost the market via publicly financed share purchases have only drawn criticism. The benchmark Nikkei stock average, at 15,762, is down 40% from its 1989 high point of 38,915, and Jardine Fleming strategist Giles Ockenden thinks there's a 50% chance of the Nikkei plummeting to 12,000 by yearend. Amid such depressed sentiment, Rotterdam-based Robeco fund, with $5 billion in assets, has pared its Japanese holdings by nearly half, to 5.5% of the total fund. At the same time, it has raised its holdings of U.S. equities to a record 51% of assets.

Global fund managers aren't the only Japan bears. Yutaka Uda, manager of Barings Japan Fund, beat the market with a 14.8% gain during the first quarter. His strategy was to buy out-of-favor domestic players such as SXL Corp., a profitable Japanese homebuilder whose shares rose 35% in the first quarter. But he fears that low interest rates and poor investment prospects will prompt more and more Japanese investors to move money out of the country in search of higher returns. "There is a lot of capital outflow pressure," he warns.

Still, fund managers find a few companies worth buying. Uda is betting on export-oriented blue chips, such as Canon and Hitachi. And Jonathan Dobson, whose Jardine Fleming Japan OTC Fund was up 10.1% in the first quarter, favors some small electronic components makers including Nidec Corp. and Yamaichi Electronics Co.

"CRAZY" MARKET. If Japan is all gloom and doom, Europe and its new currency represent the bright future for money managers. Many think the biggest beneficiaries of the euro will be Spain, Portugal, and Italy, where low inflation, strong growth, and falling interest rates already are fueling an equity boom. "The Italian market went crazy in the first quarter," says Fidelity Italy Fund manager Emanuele Antonaci, pointing to the market's 47% surge, in lira terms. The first quarter's third-best fund, Fidelity Italy, beat the market by 4% by focusing on small and midsize companies, along with bank and telecom stocks.

Despite their misgivings about Wall Street's high valuations, fund managers are not abandoning the U.S., where a series of banking and telecom mergers have helped keep the bull market going strong. Putnam Emerging Information Sciences Fund jumped 26.8% in the first quarter. Manager Roland W. Gillis credits his holdings in small U.S.-based Internet stocks such as Lycos and CMG Information Services. He's clearly willing to pay a premium for high growth: The average price-earnings multiple for the fund is 39. However, Gillis expects that technology stocks will pull back because valuations are currently so high.

Asian-induced volatility was the name of the game for most of Latin America in the past year. In the first quarter, most of the best regional funds took big positions in Brazil, which is benefitting from the government's strong defense of its currency. Dominic Rossi, manager of Threadneedle Investment Management Ltd. Latin America, thinks Latin America's two largest economies, Brazil and Mexico, will outperform the region in 1998. Mexico's willingness to defend its currency makes Rossi especially optimistic about a turnaround there.

What's next? America's and Europe's ebullient markets have a number of managers steeling themselves for a correction by late spring, especially if there's a rise in U.S. interest rates. Some intrepid investors are even moving deeper into Asian markets in search of cheap buys. Jong Rhee, manager of Baring Korea Feeder Fund, for example, insists that Kim Dae Jung's new administration will goad the chaebol industrial conglomerates into restructuring. That could spark another rally in Seoul. He is especially high on Samsung Group, noting that one of its units' planned $760 million sale of a heavy machinery division to Volvo is evidence of a serious paring-down in progress. But right now, Jong is part of a slim minority. Most of his competitors are sticking by the big-cap markets of the West, even if they're getting edgy about their heights.