May 19, 2004 — Mutual funds that focus on European stocks can provide investors with market-beating returns. These funds have performed well over the past five years, despite weakness in the broader European market.
Historically, international investments have offered diversification because there was low correlation between the U.S. and foreign stock markets. In recent years, however, the correlation has increased. Foreign markets now more closely follow the U.S. market, though not to the same magnitude. This greater correlation stems from the globalization of financial markets and the world economy. Investors have more access to international stocks, especially through international mutual funds. Financial markets around the world are now more closely linked, while huge multinational companies are more affected by the economic cycles of the countries where they do business.
While the correlation between the U.S. and foreign markets has increased, profitable opportunities still exist overseas, particularly in Europe. We looked at the 120 European equity funds in Standard & Poor’s database, including funds with multiple share classes. The average performance for these funds for the one-, three- and five-year periods through April was impressive, as indicated in Table 1 below. The average fund’s return easily beat the return of the MSCI Europe index in all three periods. An added bonus was these funds, on average, also beat the S&P 500-stock index in each period.
However, when choosing a European fund, investors should keep an eye on two important factors. The first is the outlook for the European stock market, and the second is foreign currency risk.
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The outlook for the European market is not as bright as it was a few months ago, when European stocks were moving solidly higher. “We have recently turned more cautious as we believe growth in the global economy is losing momentum,” says Standard & Poor’s European strategist Clive McDonnell. “Of particular concern are the efforts by policy makers in China to slow growth there. This could have a significant impact on European growth prospects as exports are the primary driver of growth at the moment, and Asia is an increasingly important export destination after the U.S. With the market having discounted lots of good news so early in the year, there is clearly a risk of a significant correction in the short term.” Still, he notes earnings growth prospects remain good (18% this year for the S&P Europe 350-stock index) and valuations are not excessive (the S&P Europe 350 trades at about 14 times estimated 2004 earnings).
The cautious near-term outlook for the European market doesn’t mean investors should avoid European equity funds. Instead, it underscores the importance of choosing a fund with a strong track record and low expenses. As McDonnell noted, earnings growth for the full year still looks good and valuations are not excessive. Indeed, the funds we looked at performed very well despite the decline of the MSCI Europe index in the three- and five-year periods. The index even trailed the S&P 500 significantly during the five-year time frame. (See Table 1)
The other factor to keep in mind when choosing a European fund, or any international fund, is foreign currency risk. Buying and selling foreign stocks must be done in the local currency, exposing the investor to risks that those currencies may fluctuate while the stock is held. If the foreign currency has appreciated against the U.S. dollar, a fund benefits because the proceeds from selling the stock will be worth more when converted back into U.S. dollars. Conversely, if that foreign currency has weakened against the dollar, the proceeds from the sale will be worth less. Expressed another way, a weakening foreign currency (i.e., a strengthening U.S. dollar) reduces returns, while a strengthening foreign currency (i.e., a weakening U.S. dollar), boosts returns.