Offshore Funds: Small Caps, Big Year

This was supposed to be a banner year for world markets. The conventional wisdom 12 months ago was that the U.S. economy would slow gracefully. Europe would blossom with entrepreneurs, venture capitalists, and innovative new companies, while old-line banks and state telecom operators would become more efficient through cross-border mergers and competition. The developing countries finally appeared to be throwing off the pall of the Asian and Russian crises of 1997 and 1998 and hatched their own New Economy companies. Even Japan seemed on the road to recovery. Fund managers could hardly go wrong--especially if they were in technology.

This spring, however, investors suddenly woke up to the emptiness of growth-without-profits Internet business models. A panic over slower growth in big tech companies ensued. The Nasdaq plunged in March, and many blue-chip tech stocks followed them later in the year. Now, markets are topsy- turvy. The U.S. economy is still fairly strong. But high oil prices and rising interest rates threaten to squelch the first real growth spurt in Europe since the late '80s. The emerging-markets recovery now looks illusory--except in a few places such as Mexico, Brazil, and Poland. Asia's dispirited tigers struggle to make headway on their debt overhang. And Japan's markets seem weaker than ever, with bankrupt insurers poised to liquidate portfolios. World market indexes are mostly flat in dollar terms: The Dow Jones Global Index for Europe for the 12 months ending Oct. 1 was up 3%, the Asia/Pacific index (excluding Japan) was down 2%, with Latin America, a rare bright spot, up 29%. Year-to-date numbers tell a grimmer tale. In dollar terms, as of Oct. 23, Japan was down 21%, France 15%, Germany 23%, while South Korea, Thailand, and Indonesia had fallen by around 50%. And the U.S. market is just hanging on. The Standard & Poor's 500-stock index was down 5%.

What's a mutual-fund investor to do? With broad markets hit so hard, the most successful fund managers seem to be stock-pickers--notably those whose portfolios are loaded with small-cap stocks. That certainly emerges from BUSINESS WEEK's annual ranking of over 500 of the largest offshore equity funds, with assets totaling $214 billion. The funds are based outside the U.S., typically in tax havens such as Luxembourg or the Channel Islands, so they withhold little or no tax. Fund companies can't market them to American investors because the U.S. Securities & Exchange Commission doesn't regulate them. Still, their performance sheds light on which investing strategies paid off in the last 12 months--and which might do so in what promises to be another unsettling year for investors.

Using data from the mutual-fund tracking service of Standard & Poor's Micropal, which like BUSINESS WEEK is a unit of The McGraw-Hill Companies, we show risk-adjusted performance, fees, expenses, and top portfolio positions.

To rank the funds, we measure their gross returns against U.S. Treasuries, the global standard for riskless investment. 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 Oct. 2. This year, 21 funds earned A grades, our top risk-adjusted rating (table).

The upshot: It was a particularly good year to be in European small caps. Four of the 10 funds with the best one-year records were in that category, with returns between 108% and 156%. The Internet boom was a big factor. Small- cap managers "had tremendous opportunities to invest in dot-com stocks in the fourth quarter of last year and the first quarter of this year," says Andreas Utermann, head of European equities at Merrill Lynch Investment Managers in London.

But that's not the entire small-cap story. The best fund managers of this sector tapped the wellspring of opportunities presented by a changing European business climate, from high tech to temporary employment. "The real winners [among companies] are those that use technology to enhance businesses," says James Tew, head of European research for S&P's fund services in London.

GOOD STORY. The past 12 months' small-cap performance will be tough to repeat. The initial public offerings preceding the tech collapse brought a lot of weak companies to market, says Graziella Marras, who manages the Fortis L Equity New Market Europe C Fund, a small-cap fund that returned about 108% in the 12 months ended Oct. 2. Since spring, she's stayed away from most IPOs, adding selectively to quality, core holdings. Her biggest stake--10% of the fund--is Autonomy Corp. PLC, a British software company that specializes in information retrieval, on and off the Web. The Nasdaq and Easdaq-listed company's shares rose 245% in dollar terms from Dec. 30, 1999, to Sept. 29, 2000.

Gerd Philippaerts, manager of the Fortis L Equity Biotechnology World C Fund, scored a 150% return for the 12 months ended Oct. 2. It was a big year for biotech IPOs, but he predicts a shakeout: "Those companies with the most advanced technology and the broadest approach will attract the most business. You have to be in the spotlight to advance."

Is it time to bail out of Europe, where growth is slowing and the euro has hit record lows? No, insists Jean-Paul Betbeze, chief economist at Credit Lyonnais in Paris. For patient investors, Europe is still a good story even with a slowdown. "Profits are in pretty good shape in euro land, better than in the U.S.," Betbeze says. And Europe's business restructuring will keep paying off. In France especially, he says, companies "spent a lot of the 1990s slimming down and getting into shape. They are in a better position to resist adverse situations."

In any case, an economic slowdown will probably stop the rise in U.S. and European interest rates, which would be good for stocks. "By second quarter next year, the [U.S.] Fed could be thinking of cutting rates," says Robert McKee, chief economist for Independent Strategy Ltd., a London-based investment consultancy. "The markets haven't built that into [their] equations yet."

CONVERGENCE PLAYS. For those with a long investment horizon, there are the so-called convergence plays on Eastern and Central European countries that hope to join the European Union in the next decade or so. The aspirants have an incentive to push ahead with such politically difficult tasks as bank restructuring and privatization. Some funds investing in the region had returns in the 20% range over the 12 months ending Oct. 2. Because the bourses have been hurt by the worldwide flight to quality since March's tech crash, there are some real bargains, says Andreas Gummisch, manager of the $323-million DWS Europe Convergence Equities Fund, part of Deutsche Bank's retail fund group. He likes telecom operators such as Hungary's Matav and Poland's TPSA, dominant players in fast-growing markets, boasting price-earnings ratios of less than 20.

Small, unknown stocks and New Economy plays may be hot in Europe. But not in Asia. After topping the tables last year, Asian funds were among the weakest in BUSINESS WEEK's one-year performance ranking. That's because of Japan's woes and the unresolved problems of the 1997-98 Asian crisis that still plagues Korea, Indonesia, and Thailand.

With a selective blue-chip strategy, however, it is possible to play Asian markets profitably, says Roger Ellis, manager of the $700 million Fleming Flagship Fund Asian Opportunities in Hong Kong. He turned in a solid 31% return in the latest year, mostly by bailing out of tech stocks just before the Nasdaq meltdown and concentrating on profitable Old Economy plays in the region's most stable economies: Hong Kong, Singapore, and Taiwan. Hong Kong and Taiwan, he says, stand out in Asia as havens of good management, transparency, and reasonable treatment of shareholders. He likes HSBC Holdings (HBC) and its subsidiary, Hang Seng Bank, as well as Taiwan Semiconductor Manufacturing Corp. (TSM)

The big disappointment remains Japan. At many companies, old management remains in place. Bank balance sheets are still laden with bad loans. "They aren't increasing efficiency or securitizing their loans fast enough, and their business plans are evolving very slowly," complains Tim Orchard, who manages the $566 million Mercury Selected Trust Japan A Fund. He concentrates on big electronics exporters such as Sony (SNE), Murata, and Canon (CAJ), though their fortunes could suffer if the U.S. economy slows. For her part, Elizabeth X.Q. Tran, chief investment officer for Asia in American Express Asset Management's Hong Kong office, was optimistic about corporate restructuring last year. This year, she says, the "glacial pace of reforms" is disappointing. She recommends Toyota Motor Corp. (TM) for its efforts to expand into telecoms and NTT DoCoMo for the potential of its wireless Internet technology.

If there's a sleeper region in the world, it may be Latin America. Mexico's economy should grow by 7%, Brazil's by 3.7%, and Chile's by 5%. Both Brazil and Mexico have made great strides in managing their economies: Brazil rapidly returned to international debt markets after its January, 1999, devaluation, while Mexico appears likely to escape the currency crisis that usually follows a presidential vote.

But foreign investors still flee Latin America's stocks at the first hint of global market jitters, laments Luiz Ribeiro, senior portfolio manager of the ABN Amro Latin American Equity Fund (RLAEX) in Sao Paulo. His fund turned in a 34% 12-month return as of Oct. 2. But that only put him 83rd in BUSINESS WEEK's overall ranking. Ribeiro stuck with Latin telecoms, which were hurt during the tech meltdown but are recovering. He particularly likes Brazil's Telemar and Brasil Telecom (BRP). Since August, however, he has been shifting into consumer stocks. "The consumption story in Latin America is quite powerfuland valuations are quite low," he says. His favorites? Brazilian brewer/bottler Ambev and Mexican brewer Grupo Modelo (GPMCF), which makes the popular Corona brand.

Mark Perl, who runs the Morgan Stanley Dean Witter Sicav Latin American Fund, says that Latin America's stocks held up better during the current downturn than in the past. He thinks investors may be starting to appreciate the region's solid fundamentals, even though flight from risk will continue to hurt Latin American shares until the U.S. market settles. At that point, Perl says, Latin America will start climbing.

In today's uncertain markets that sounds promising. Investors and fund managers around the globe are looking forward to the day when they can say the same.

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