Offshore Funds Take Flight Again

With worries about war and SARS fading, they moved up

After more than three years of dodging declining markets, money managers greeted a surprisingly bullish second quarter with sighs of relief. With the Iraq war officially over and the memory of SARS fading, markets everywhere moved up smartly. Indeed, every one of the 500 mutual funds managed outside the U.S. and tracked by BusinessWeek's quarterly Offshore Funds Scorecard finished the quarter with positive returns. And more than 96% turned in double-digit gains for the quarter ended June 30. A look at the funds' 12-month performance, of course, is more sobering: Only five of the top 25 had positive returns over a yearlong period. That's a reminder that quarterly performances can vary widely.

In the latest quarter, German and European equity funds came out on top, with funds focusing on German stocks taking six of the top 10 spots in the ranking. Biotech and European small-company funds also did well. Capital outflows from the U.S. certainly helped buoy the performance of non-U.S. markets: In the first five months of this year, U.S. investors snapped up $25.5 billion in foreign equities, mostly in Europe and Asia outside of Japan, says Morgan Stanley.

The gold medal went to DG Lux Lacuna Apo BioTech, the best performer among the 500 funds, clocking a sizzling 57.66% return. Although run jointly from the German town of Regensberg and Zurich, the fund, like most of its biotech counterparts in Europe, profited by investing in the red-hot American biotech industry. The fund holds 75% of its investments in small and midsize companies based in the U.S., and it doesn't plan to tinker with that strategy. "Investors who are interested in growth must sooner or later invest in biotech, where share prices are growing an average of 30% to 35% per year," says Christian Pistor, manager of research at four-year-old Lacuna, which has a total of $170 million under management.

Offshore funds are typically based in tax havens such as Luxembourg and the Isle of Man and cannot be marketed to U.S. residents because they don't file reports with the Securities & Exchange Commission. But they represent the collective judgment of fund managers from around the world. Standard & Poor's, like BusinessWeek a division of The McGraw-Hill Companies, did the number-crunching for the scorecard.

The biggest surprise of the quarter was the sudden thaw in the three-year Teutonic freeze. German markets have been among the worst global performers since 2000. But this year, they staged an impressive comeback, with the DAX blue-chip index jumping 13.38% so far this year and 40% in the second quarter alone. "There have been a few glimmers of hope [for] the economy," says Frederic de Merode, a portfolio strategist at Fidelity International in London. "Business confidence is beginning to pick up and unemployment is falling after rising for a year."

Some would say German equities had nowhere to go but up. They were 75% off their highs of spring, 2000, before the recent bounce. That made the stocks appear pretty cheap to value investors. Throw in some encouraging noises from Chancellor Gerhard Schröder that Berlin is getting serious about structural reforms of labor laws and pensions, and the story starts to look promising. No one is saying that the German economy is out of the woods yet, but there has been enough encouraging news to entice buyers back into the market. Indeed, total monthly equity turnover on German stock exchanges jumped 22% in June, to $91 billion, according to the Deutsche Borse Group in Frankfurt.

Beaten-down German blue chips have attracted the lion's share of money. Markus Zipperer, who manages No. 6-ranked CS EF (Lux) Germany fund at Credit Suisse AM Funds in Frankfurt, tapped into Deutsche Telekom for its high cash flow. He also maintained his holdings in Siemens, whose stock soared, along with other stocks in the tech sector. Across Europe, many of the best-performing funds invested in telecom and Internet stocks, which may have hit bottom. Investors say these companies were helped by the combination of strong cash flow and a weak dollar. Many small-cap stocks also rode the coattails of bigger stocks that rose. "After the Iraq war, the big-cap stocks were the first to move," notes Ed Burke, fund manager at the INVESCO UK Equity Fund. "But then the initial leadership in the market was reversed" as small caps advanced.

Guido Marveggio, portfolio manager at the No. 2-ranked Special Europe Stock Fund run by Julius Baer in Zurich, saw his small- and midcap-heavy fund soar 47% in the second quarter. Among the best performers: German telecom firm and Internet service provider T-Online International. But while Marveggio is optimistic about certain stocks, he's only cautiously positive about small caps as a whole. "After this rebound, the potential is not that large anymore," he says. "If the U.S. is not growing [strongly], Europe will have to struggle."

Success in biotechnology, of course, depends on factors other than the performance of national economies. With huge research costs and little revenue, small biotech stocks typically live or die by the government drug-approval process. Top-ranked Lacuna scooped up shares in U.S. biotechs last fall -- a time when risk-averse investors were giving them a wide berth. Lacuna's bet paid off in the second quarter, when the Food & Drug Administration cleared six new drugs -- three of them made by leading picks of the fund. These included Houston-based Tanox Inc. and San Francisco-based Genentech Inc., both of which make Xolair, an asthma drug; Novato (Calif).-based BioMarin Pharmaceutical, which produces Aldurazyme, an enzyme- replacement therapy to counteract a life-threatening disease called MPS I; and Livingston (N.J.)-based Columbia Laboratories, manufacturer of testosterone enhancer Striant. All told, Lacuna's portfolio, which holds 80% of its investments in biotech companies and 20% in medtech companies, paid off in spades. "When a drug receives approval, small and midsize stocks valued between $250 million and $1 billion can see revenues grow by 100% in a year," says Pistor.

The stellar second-quarter returns weren't limited to small biotechs. No. 4-ranked Fortis L Equity Biotech World C gained 39% in the second quarter and 21% in the past 12 months investing in mostly large-cap biotech stocks. Fund manager Gerd Philippaerts likes that these stocks march to their own beat. "Unlike technology companies, these do not depend on the [economy] to have a high-growth profile," he says. Philippaerts is bullish on Genentech, which has made great strides in cancer research. Philippaerts also is a fan of Millennium Pharmaceuticals Inc. and its new bone marrow cancer-fighting drug Velcade, which was approved by the FDA in May. Talk about big bets: Millennium, Genentech, and Amgen account for 27% of the Fortis fund.

In Asia, the big question is whether Japan is back as an investment destination. The Nikkei 225 is up 12.08% this year, and some analysts still see many Japanese stocks as undervalued. "Japan Inc. has slowly but steadily restructured and reduced its cost structure, which will lead to better earnings," says Shigeda Kouda, manager of Goldman, Sachs & Co.'s Japan Fund. But the view of Japa-nese markets is mixed. "Stocks are cheap in Japan, but cheap doesn't mean value," says David Herro, manager of the Kansas City (Mo.)-based Oakmark International Fund. He notes that average return on equity for Japanese companies is 6% to 7%, compared with 13% to 14% for Europe and 15% to 16% for the U.S.

After getting hammered in the first quarter, Korean stocks rebounded strongly, with the Kospi index finishing up 31.3% in the three months ended June 30. The award for the most impressive comeback goes to Jardine Fleming's Korea Fund. It was the scoreboard's worst-performing fund in the first quarter, when it lost 19%, but it roared back with a 36.95% return, ranking No. 11 this quarter. The fund's two largest holdings are Samsung Electronics Co. and steel company Posco, both of which have benefited from strong exports to China.

As always, the fortunes of offshore funds are tethered to the world's major economies and equity markets. There's growing concern that currencies in Asia are being held artificially low by their central banks to pump up exports. If they are allowed to appreciate against the dollar, Asian exporters' earnings could plummet. Plus, with a strong euro chipping away at corporate profits in Europe, markets may have a difficult time keeping up the momentum. The upshot is if there are no signs soon of a broad-based economic recovery, fund managers may have to start running for cover all over again.

By Frederik Balfour in Hong Kong, with Gail Edmondson in Frankfurt, Laura Cohn in London, and Irene M. Kunii in Tokyo

    Before it's here, it's on the Bloomberg Terminal.