The Best Offshore Funds

Even in volatile times, they're still a good long-term bet. Here's how the 500 largest stack up

These are trying times for investors. Asia's prognosis remains bleak. Russia has devalued its currency, and Brazil is on the verge of doing so. The U.S. market continues to churn well below its record highs, while Europe shivers from the chill winds blowing from Russia and Asia. Global fund managers' discipline and commitment to a coherent long-term strategy have been sorely tested.

Few people were expecting great gains in 1998 at the outset. But the sizzling first-half performance of U.S. and European markets lulled some investors into thinking that a new era had dawned. Wrong. Although technology and savvy macroeconomic management may be driving a New Economy, market volatility and social turbulence come with them. "The consensus is that it's the end of the world," says Crispin Murray, vice-president of European equities at BT Australia Funds Management, summing up what he perceives as the overly pessimistic mood among managers.

Investors are beginning to realize that, if they don't have one already, they need a survival plan for tough times. Luckily, a well-diversified portfolio of global equities has invariably produced the best results over the long haul. For most people, a professionally managed fund is still their best investment choice. A good place to begin is BUSINESS WEEK's annual ranking of the world's 500 largest offshore equity funds, with assets totaling $111 billion. These funds are domiciled outside the U.S., in tax-favored locales like Hong Kong or the Channel Islands. Their major appeal is that they have little or no income or capital-gains taxes withheld.

Because they are not regulated by the Securities & Exchange Commission, offshore funds can't be marketed to U.S. residents. Investors overseas often have a difficult time obtaining information on these funds, so BUSINESS WEEK has developed an annual risk-adjusted ranking. Using the data of Standard & Poor's Micropal--like BUSINESS WEEK, a unit of The McGraw-Hill Companies--that tracks mutual funds, we've included information on performance, fees, expenses, and even top portfolio positions.

To rank the funds, we measure their gross returns against U.S. Treasuries, widely considered the global standard for riskless investing. Then, we compare how the funds performed against the Financial Times/Standard & Poor's Actuaries World Index and rank them over one-, three-, and five-year periods through Sept. 30. To simplify the Scoreboard, we have changed the ranking system from arrows to traditional letter grades. This year, some 60 funds received an "A," our top risk-adjusted rating.

Caution is the watchword of fund managers in our offshore universe. Most are more worried about preserving capital than gambling on sizzling gains. They favor large companies. They want healthy balance sheets, solid cash flow, and high-quality management. And they're in no mood for surprises. That's especially true in Asia. Managers of Asian funds are sticking to high-quality companies and focusing on the region's better-regulated and more transparent markets, such as Australia and Hong Kong.

DON'T DO IT. Volatile markets are a reminder that long-term discipline is a key to good performance. Typically, equities tend to perform better over virtually any 10-year period--indeed many pros say that anyone with less than a five-year investment horizon doesn't belong in the stock market. But with such extreme volatility, investors may be tempted to time the market. Don't do it, advises Keith R. Ferguson, regional-investment director at Fidelity Investment Management (Hong Kong) Ltd. "Try to have a clear strategy and a clear idea of how much risk you can tolerate, and stick with it," he says.

Most fund managers still prefer Europe. Governments there are getting out of business by privatizing as fast as the markets will allow. And the Jan. 1 launch of the euro, the European Union's single currency, could juice up profits as companies cut costs and break out of their domestic confines by gearing up to attack a single market of 300 million consumers. As a result, merger-and-acquisition activity is on the rise, from $135 billion four years ago to $370 billion so far this year, according to Securities Data Co. Besides, European management is starting to cultivate shareholders actively. "Continental Europe is experiencing a supply-side revolution just like Margaret Thatcher brought to England and Ronald Reagan brought to America," says Keiran Gallagher, London-based manager of the Newton Continental Europe Fund, the sixth-ranked fund over the past five years.

Gallagher's approach to Europe is to make big bets on about 40 companies, primarily blue chips. But his fund has 15% in dividend-paying utilities, a classic defense against unpredictable corporate earnings. He likes Germany's electric company Viag, Spanish electric utility Iberdrola, and France's Vivendi, a global water-services and telecom company. Some rivals are on the same tack. Gartmore CSF Continental Europe has been heavily invested in telecoms for the past year. The fund's top holdings include Germany's Mannesmann, Telecom Italia, and Spain's Telefonica de Espana. "Deregulation will drive down prices and grow the industry," says fund manager Adrian Darley.

Skeptics, however, think Europe may turn out to be a disappointment. "Europe may have more potential, but America has a better track record in delivering results," sniffs Gary Lowe, the London-based fund manager of seventh-ranked Mercury North American. Lowe favors pharmaceutical companies such as Pfizer Inc. and Warner-Lambert Co. He also has sizable positions in technology companies like Microsoft Corp. and America Online Inc.

Although U.S. markets are being whipsawed by weak earnings and a slowing economy right now, fund managers like its long-term potential. Just ask Roland Gillis, manager of Putnam Investments' Emerging Information Sciences Trust, ranked No.2 over the five-year period. He has deftly maneuvered through the minefield of small high-tech stocks. Earlier in the year, he dumped semiconductor stocks and avoided their subsequent pummeling. Savvy trading of volatile Internet stocks, including CMG, Broadvision, and Lycos, has also paid off. But this quarter, his big winners have been telecommunications stocks such as GeoTel Communications., Metromedia Fiber Network, Ascend Communications, and Qwest Communications International. All specialize in supplying advanced networking technology mainly to U.S.-based phone and cable companies, and some are takeover candidates.

BIG NAMES. Some managers, though, are opting for a less daring strategy. As the market soared in the first half of this year, some played for safety by moving into less risky stocks. Rotterdam-based Marnix Vriezen, for instance, who runs the Robeco Group America Fund, switched to defensive stocks such as regional telephone company Ameritech and electric utility Southern Co. By selling his stakes in most small-cap stocks such as PC-equipment maker SCI Systems, he was able to load up on big names such as telecom-gear supplier Lucent Technologies, as well as global financial firms AIG and Citigroup.

For other players, risk creates opportunity. Fleming Capital Management President Jonathan Simon, who oversees two of this year's A-rated funds, Fleming FF American and Jardine Fleming American Growth, used the sell-off in consumer cyclicals to increase his funds' exposure to undervalued retailers, media companies, and financial firms. One of his funds' big winners this year has been Dayton Hudson Corp., a Midwestern retailer Simon likens to Wal-Mart Stores Inc. Dayton Hudson derives the bulk of its profits from its Target Stores Inc. franchise. At the beginning of October, the stock was $32 and trading at a modest 14 times earnings. Two weeks later, when Simon sold his position, the stock was at $45. While Simon concedes that such major successes were harder to come by this year, he's optimistic about 1999. "We're excited about the bargains that will be available in the coming year," he says.

Japan's battered stock market would seem to be a paradise for bargain hunters. The country, however, remains as big a question mark as ever. Its economy is in recession, and its banks are tottering. But the recent bank recapitalization plan, which provides about $550 billion to shore up shaky banks, may mark a turning point. And since Japan accounts for nearly 75% of Asia's economy, there's a lot riding on the plan. Most foreign fund managers, however, remain skeptical that it will work and allow Japan to get its bad-loan debacle behind it. "They announced a lot of money. But there are no details at all that I can see on how that money will be used," worries Dennis Clough, London-based manager of the Schroder Japan Fund. "The problem is getting bigger and bigger."

Indeed, almost every sector in Japan's economy continues to weaken. "It is very hard to take one sector" and feel optimistic about its prospects, says Paul S. Kirkby, who runs the GAM Japan Fund. Still, there are some enticing opportunities. Clough favors Fuji Photo Film Co., whose aggressive price-slashing is causing headaches for Eastman Kodak Co. Although the strong yen will affect earnings, Clough figures Fuji's strong balance sheet, solid market position, and hefty free-cash-flow outweigh the currency risk. Another favorite is pharmaceutical company Takeda Chemical Industries Ltd., which is becoming more focused on returns to shareholders.

Japan's economic woes are holding back the rest of Asia. Funds specializing in the region remain among the worst-performing over the past five years. The best-performing Far East fund, Citibank's Industrialized Asia Pacific Citiportfolio, ranks a miserable 235th on the list. Pansy Phua, the Singapore-based fund manager who runs it, was lucky enough to get the last big move right. She reduced her cash position in September and bought regional blue chips just in time for the powerful early-October rally.

HARD-HEADED. Like other savvy Asia players, Phua favors companies that have lots of cash, pay dividends, and offer solid prospects. Her biggest holdings are National Australia Bank Ltd., Hong Kong utility China Light & Power, and Hong Kong property conglomerate Cheung Kong. "These are defensive companies that you know won't go bust," she says. All the same, even that hard-headed approach may not keep investors happy. Phua's fund has seen assets shrivel to just $44 million from a peak of $350 million in early 1994.

After watching their funds hemorrhage for months on end, it's no wonder that managers are deeply skeptical. In recent weeks, most Asian currencies have stopped their slide while the yen has strengthened, making Japan's neighbors more competitive. Still, Phua and others worry that the markets will be on a roller coaster for months to come. "Sentiment is still fragile," she cautions. And until market confidence is restored, equity investors will need to keep their investment strategy firmly on track.