Offshore Funds: Asia Is Back

Japan really shines, but Europe looks dismal

After years of anemic growth followed by a steep recession in 1998, nobody would fault you for concluding the Japanese economy was down and out. But offshore equity funds investing in Japan have been telling a radically different tale lately. Amid signs that long-needed corporate restructurings are finally getting under way, the Japanese stock market turned in a dazzling first quarter. In U.S. dollar terms (table), some Japan small-cap funds soared by more than 50% in the quarter.

Japanese funds were hardly the only big gainers in 1999's opening months. Across Asia, the market rally that began last year amid expectations of an economic revival has continued to benefit investors in Pacific Rim funds. Latin American and U.S. technology funds have also recorded strong gains. The major exception: funds investing in Europe. A fizzling euro, weak German economy, and war in the Balkans are adding up to miserable returns.

Whether you believe battered European funds are poised for revival or think the best is yet to come in Asia, BUSINESS WEEK's Offshore Fund Scoreboard can help you put your assets to work. Because they don't file reports with the U.S. Securities & Exchange Commission, offshore funds are marketed only outside America. But they reflect the judgments and performances of U.S. and international investment pros who keep close watch on global markets. We track the world's 500 biggest equity funds quarterly, using data from Standard & Poor's Micropal (like BUSINESS WEEK, a unit of The McGraw-Hill Companies). Up-to-the-minute performance data on these and other equity and fixed-income funds are available at www.

Eleven of the quarter's 25 best-performing funds were invested in Japan, with the leader, LO Invest Japan OTC fund, surging 64.17% in U.S. dollar terms. While much of the foreign money flooding into Japan lately has been plowed into blue chips, the biggest winners were funds that cannily invested in smaller companies. Indeed, the quarter's top four funds all rode the crest of Japan's four-month-old small-cap rally.

The small-cap market is still relatively unexplored territory for foreign-based stock-pickers, even though many of the sector's leaders are globally popular tech stocks. Morgan Grenfell Japan Small Companies, up 45% in the quarter and 86% for the past 12 months, has a big stake in Yahoo! Japan, a venture of the U.S. Internet company and Softbank Corp. Yahoo! Japan's pretax profits tripled, to $3.3 million, for the fiscal year ending in March on 50% sales growth. The fund got into the stock at about $68,000 a share after Yahoo! Japan went public in 1997, and has since seen the shares jump to $300,000 after a 2-for-1 stock split in March. Another Morgan Grenfell favorite is Trend Micro Inc., a maker of antivirus software that is up 81% this year. "If you want to buy growth in Japan, the small-company sector is where it is at," says James Pulsford, who, with partners Simon Davis and Eric Forday, manages the Morgan Grenfell fund.

IN THE DOLDRUMS. This sector is not for the faint-hearted. The Japanese small-cap market is rumor-driven and hugely volatile, and even bulls wonder whether it can continue its recent torrid pace. With the Japanese economy remaining in the doldrums--Moody's Investors Service estimates gross domestic product growth will be zero this year--other money managers warn that the small caps have simply grown too expensive. "My suspicion is that the over-the-counter market is at least due for some consolidation, if not a little backsliding, in the near future," says ING Barings small-cap strategist Jonathan Allum.

There may also be some backsliding ahead in another hot Asian market--India. Several Indian funds ranked high on the BUSINESS WEEK list, a couple gaining more than 33% on the strength of a surging economy. But with India expecting soon to get its sixth Prime Minister in three years in the wake of the government's recent fall, a repeat of the first quarter's bull-market run seems remote.

For all the excitement in Asia, fund investors in Europe are glum. Germany, the Continent's biggest economy, has been a crushing disappointment to those who thought the euro would boost stock prospects. The currency has slipped 10% since its debut on Jan. 4, cutting deeply into foreign investors' returns. Declines of 10% or more, in dollars, marked many of the worst-performing German funds as the big-cap DAX index fell 7% in local currency terms in the first three months. Although it has since recovered some of the losses, "the DAX has clearly underperformed [other markets] because of weaker German and European economies," says Walter Schmidt, president of Gerling Investment Kapitalanlagegesellschaft in Cologne, which has $2.4 billion under management.

Across the Continent, investment managers are cheered by recent interest-rate cuts but say stocks are still richly priced because of expectations that markets would surge after the euro's debut. Moreover, cyclical German stocks have been hurt by the sluggish economy. NATO attacks in Yugoslavia haven't sat well with investors, either. "The economy is very dull, and there has been a lot of uncertainty on the political front," says David J. Warren, a London-based portfolio manager for T. Rowe Price Associates Inc.

Still, investors betting on a European rebound might find some scattered successes. Telecom stocks such as Mannesmann in Germany or Vivendi in France are promising, Warren says. Giant mergers such as the planned marriage of Deutsche Telekom to Telecom Italia are making some fund managers hope for even more. Overall, stocks could get a further boost if legislators let Germans set up tax-deferred retirement plans similar to American 401(k)s. Politicians in Bonn say that is unlikely to happen in 1999. But if and when it does, "the market will explode," predicts Christoph Bruns, head of equity fund management at Union Investment in Frankfurt. "The magic word is pension reform. When it happens it will be quite dramatic. There's tons of money."

European bulls also argue that rising growth and an eventual stabilization of the euro will also translate into stock-market gains. Such cyclicals as steel, paper, and chemicals "have started to move" lately, says David Bowers, a London-based European equity strategist at Merrill Lynch & Co. Analysts now expect corporate earnings on the Continent to rise 12% for the year, down a few percentage points from the outlook in January, but still respectable. Some pros are especially fond of France, whose market is more diversified and economy healthier than Germany's.

TAKING OFF. Fund managers are also getting more and more bullish on Latin America. Many believe Latin funds could continue to pay off for the remainder of 1999, perhaps even at the 15%-plus rates some posted in the opening quarter. Mexico's economy is perking along next to the U.S., while Brazil's devaluation has proven less onerous--at least to investors--than expected. "There is considerable upside in Brazil," says Robert Davy, who manages the Schroder & Co. Latin America fund that ranked No. 22 on our Top 25 list. Declining interest rates, he says, could spur more growth.

Analysts high on Latin America argue that capital flows into the region are just taking off. "We're at the very early stages," says Davy. While GDP is expected to shrink this year in Brazil and Argentina, the outlook is more promising in Mexico, where the peso is stable and the economy may expand nearly 3%. Deutsche Bank Latin America strategist Jane Heap expects corporate earnings in Mexico to climb 15% this year, a rate that should encourage even those investors worried about the national elections next year. "Economic management is very good," argues Heap. "There's every reason to believe that things are stable." For fund investors intrigued by global markets, that translates into opportunities.

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