January 3, 2006

Money Floods Foreign Stock Funds

Foreign Equity Funds and ETFs -- Year-End 2005 Review and Outlook

Nothing could stop the torrent.

Stock markets around the world soared in 2005, pumped by record amounts of new cash moving into international equity funds. Led once again by the vibrant emerging markets, foreign issues overcame a tidal wave of challenges, including record high oil prices, rising U.S. interest rates, terrorist attacks, continued unrest in the Middle East, and unprecedented natural disasters.

Apart from the commodity-rich emerging markets, the other big story in global equities was Japan, which appears to have shaken off the cobwebs of a 15-year bear market. Mutual funds and exchange-traded funds investing in Japan soared in 2005. Overall, the average international equity fund gained 17.7% for the year, while the average global equity fund, which has the latitude to invest in both U.S. and foreign stocks, rose an impressive 10.5%. In comparison, the S&P 500 climbed 5.8%.*

Not surprisingly, U.S. fund investors caught the foreign bug and found better bets abroad. According to Emerging Portfolio Fund Research Inc. (EPFR), dedicated emerging market equity funds received $16.1 billion in net inflows through mid-December, beating the record $14.4 billion established in 2003. Investors placed $3.9 billion of new money into Latin American equity funds by mid-December, compared with just $97.8 million in 2004, and $436 million in 2003. Another $7.1 billion flowed into Asia (ex-Japan) equity funds in 2005, the most since the $7.3 billion recorded in 2003.

EPFR's data also indicated that 2005 was the second best year of inflows for Japan and global equity funds, and the worst year for flows into U.S. and Europe equity funds in this decade. Currently, iShares MSCI EAFE Index Trust (EFA) and iShares MSCI Japan Index Fund (EWJ) are among the five largest exchange-traded funds, with $21.7 billion and $11.6 billion in assets, respectively, as of theend of November, according to Standard & Poor's data.

Emerging Markets: Still A Good Buy

Thomas A. Mengel, portfolio manager of the $57-million Ivy International Value Fund/A (IVIAX), attributes the surge in emerging markets primarily to continuing robust energy and commodity prices, although it varies by region. "The biggest commodity-driven market has been Russia, whose economy is heavily linked to the price of oil," he said. "However, another major commodity play, Brazil, has a more diversified economy. For instance, it boasts a strong banking sector, and the country's overall economic growth has been good."

Ron Holt, president and managing director of global research of Hansberger Global Investors and portfolio manager of the $229-million Harris Insight International Fund/N (HILAX), likes the emerging markets due to better fundamentals, attractive valuations, the development of a huge domestic demand base in China and India, and the long-term structural shift from the developed world to the emerging markets.

Despite handsome gains, the emerging markets still remain relatively cheap on multiples. According to S&P/Citigroup Global Equity Indices, such developed markets as Austria, France, Japan and Britain are trading at 12-month trailing P/E's of 21.8, 22.7, 26.8 and 22.2, respectively. By comparison, red-hot emerging markets like Argentina (12.8), Brazil (7.8), India (15.1), Mexico (7.8) and Russia (11.6) remain veritable bargains. As a whole, the emerging markets are trading at a P/E of 12.3, versus 18.1 for the Eurozone and 20.9 for the U.S.**

Nicholas Kaiser, president of Saturna Capital Corp., which oversees the Sextant and Amana funds, said that in the emerging markets "sound businesses with reasonable fundamentals are still available. The large increases in cyclical earnings make many companies even cheaper on a price-to-earnings basis."

The U.S. dollar, which has undergone a broad rally against major currencies this year, has played a large role in the fortunes of foreign markets, particularly exporters in Asia and the developing world. However, Asian nations are trading more with each other and gradually becoming less dependent on selling their wares to the U.S., somewhat softening the negative impact of the stronger dollar.

Kaiser is not overly concerned about the dollar. "Rising domestic interest rates boosted the U.S. dollar in 2005," he explained. "As there is little chance for falling U.S. interest rates in 2006 the dollar will remain strong. A collapse is highly unlikely, as a strong U.S. economy will improve the federal financial picture while also supporting imports from emerging markets."

Japan: New Engine, Sleeker Design

Japanese markets are bursting at the seams with optimism, buoyed by meaningful corporate restructuring, an improving domestic economy and the recent election victory of reform-minded Prime Minister Junichiro Koizumi and the Liberal Democratic Party.

"Japan made good progress on clearing up its bank debt problems in 2005," said Kaiser. "They voted to privatize the postal banking system, showing that the financial drags of many years standing can be removed and the need for governmental policy to fight deflation has evaporated." Kaiser said he expects the Japanese recovery to continue for at least another six months, with the Nikkei rising 20% over that period.

Mengel also believes Japan's economic revival is sustainable. "Japan is coming out of deflation, which is very good for domestic consumption," he said. "Japanese companies are also increasingly profitable."

Standard & Poor's has had a positive outlook on Japan throughout 2005 and maintains its overweight recommendation looking ahead to next year. "Our forecast is based on the strong economic and profit outlook, improved reform prospects and attractive valuations," said Alec Young, Standard & Poor's equity market strategist.

Western Europe: Looking Under the Hood

Western European stock markets have done reasonably well in local currencies, Mengel said, but not so good in U.S. dollars. (The dollar rallied about 12% relative to the euro this year). "The stronger U.S. dollar has propelled the major European stock markets, which have risen 20%-30%," he noted. "The dollar has helped Eurozone exporters, as companies enact aggressive cost-cutting and raise margins."

However, Mengel notes, the underlying European economies are weak, due to domestic issues like high unemployment and dismal domestic demand.

Young noted that although Standard & Poor's has had a positive outlook towards European equities throughout 2005, the 2006 outlook is more cautious.

Outlook for 2006: Eyes on Oil, China and the U.S. Dollar

Holt sees three main risks facing global markets in 2006: economic dislocation due to rising commodity and energy prices; geopolitical problems, including a rise in protectionism; and a potential collapse of the U.S. dollar, which would negatively impact foreign exporters, particularly Asia.

With respect to the emerging markets, Kaiser said that "markets which are broadly tied to natural resources did exceptionally well in 2005, and we forecast the trend to continue in 2006."

Mengel noted that with energy prices having stabilized from record highs, "it appears the world can live with oil priced at $60, even fast-growing Asia, which is almost completely dependent on oil imports. As long as oil doesn't jump to the $90-$100 level, this growth should continue in 2006."

Young notes that while the price of WTI crude oil averaged $56/barrel in 2005 -- a 36% increase from 2004 -- the global economy has been "surprisingly resilient" in response. Looking ahead, Standard & Poor's believes that "while energy prices may not fall dramatically, we will not see a repeat of 2005's outsized gains. Standard & Poor's forecasts WTI crude oil will average $58 in 2006, roughly in line with 2005's year-to-date average level of $57."

Mengel contends that China, with its insatiable demand for commodities and raw materials, will continue to serve as the world's growth engine. "China's economy will grow by about 9% this year, but may slow down slightly to 8.5% in 2006," he said. "On a relative basis, its demand remains quite high and will likely continue to boost the remainder of the globe's economies, particularly the emerging markets."

The ongoing process of globalization will likely dominate the landscape. Holt said this trend has benefited the world's economies, including the U.S., citing an environment of stable economic growth, low inflation, cheaper labor costs through outsourcing to China and India, and historically low interest rates.

Standard & Poor's Global Investment Policy Committee currently recommends that investors keep 20% of their investment portfolio in foreign equities.

International Equity Funds and Exchange-Traded Funds

Best Performers

Year-End Returns (%)

Worst Performers

Year-End Returns (%)

ProFunds:Ultra Japan/Inv (UJPIX)

+71.8

PowerShares Golden Dragon Halter USX Tr (PGJ)

-3.0

ING Russia Fund/A (LETRX)

+67.9

Dreyfus Premier Greater China Fund/B (DPCBX)

+1.0

Fidelity Advisor Korea/Instl (FKRIX)

+60.7

iShares MSCI Malaysia Index Fund (EWM)

+1.1

Matthews Korea Fund (MAKOX)

+56.6

iShares MSCI Italy Index Fund (EWI)

+2.3

T. Rowe Price Latin America Fund (PRLAX)

+55.8

iShares MSCI Taiwan Index Fund (EWT)

+2.3

Global Equity Funds

Best Performers

Year-End Returns (%)

Worst Performers

Year-End Returns (%)

Merrill Lynch Global Value Fund/I (MAVLX)

+34.1

Prudent Global Income (PSAFX)

-4.5

Scudder Global/S (SCOBX)

+22.5

Seligman Global Growth/D (SHODX)

+0.1

T. Rowe Price Global Stock (PRGSX)

+21.5

Eaton Vance Global Growth Fund/C (ECIAX)

+0.7

Evergreen Global Opportunities Fund/I (EKGYX)

+19.4

DFA Global 25/75 Portfolio/R

+0.8

RiverSource Global Equity Fund/Y (IDGYX)

+18.3

Hartford Global Leaders Fund/B (HGLBX)

+0.8

International Exchange-Traded Funds

Best Performers

Year-End Returns (%)

Worst Performers

Year-End Returns (%)

iShares S&P Latin America 40 Index Tr (ILF)

+52.8

PowerShares Golden Dragon Halter USX Tr (PGJ)

-3.0

iShares MSCI South Korea Index Fund (EWY)

+49.0

iShares MSCI Malaysia Index Fund (EWM)

+1.1

iShares MSCI Brazil Index Fund (EWZ)

+46.5

iShares MSCI Italy Index Fund (EWI)

+2.3

iShares MSCI Mexico Index Fund (EWW)

+43.3

iShares MSCI Taiwan Index Fund (EWT)

+2.3

BLDRS Emerging Markets 50 ADR Index Fund (ADRE)

+36.8

iShares MSCI Spain Index Fund (EWP)

+4.3

*SOURCE: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends. Preliminary data as of 12/19/05.

**S&P/Citigroup data as of Nov. 30, 2005

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