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.

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.

Needless to say, forecasting foreign exchange rates is difficult, even for professionals. Therefore, when considering foreign stock funds, investors should look for funds that have performed well regardless of whether the dollar was strong or weak.

When we evaluated European funds’ performances relative to exchange rates, we looked at the euro and the British pound. Those two currencies cover 13 European countries, including those with the largest economies and stock markets. Countries in this group of 13 include Great Britain, Germany, France, Italy and the Netherlands. These two currencies therefore provide the most practical foreign currency measures for our purposes.

While the dollar has perked up recently, over the past three years it has fallen sharply against both the euro and the pound. During the three years through last month, the dollar sank 34.9% against the euro and 24.0% versus the pound. However, during the previous two years, the dollar was the big winner. During the two-year period through April, the dollar surged 17.1% against the euro and 11.3% against the pound.

As a result, the five-year performance provides the broadest measure of a fund’s ability to weather currency fluctuations. Five years covers both the dollar’s weakness in the past three years as well as the greenback’s strength in the two prior years.

We therefore screened for the funds with the best five-year returns which also had the lowest expense ratios. We further narrowed the list to funds which also beat the MSCI Europe benchmark in the one- and three-year periods. While three of the funds have expense ratios of 1.65% or higher, those are still below the average expense ratio of 1.93% for all 120 European funds. The results are in Table 2 below.

Table 1*

One-Year Returns (%) Three-Year Returns (%) Five-Year Returns (%)
European Equity Funds +35.73% +1.07% +1.91%
MSCI Europe Index +31.20% -2.22% -2.89%
S&P 500-Stock Index +22.87% -2.36% -2.25%

Table 2*

Top Ten European Funds Ranked By Five Year Returns

One-Year Returns (%) Three-Year Returns (%) Five-Year Returns (%) Expense Ratio (%)
Mutual European Fund/Z (MEURX) +32.82% +6.02% +13.01% 1.05%
JP Morgan Fleming European/A (VEAUX) +32.78% +8.31% +5.17% 1.65%
Fidelity Nordic (FNORX) +40.15% +0.5% +3.33% 1.40%
Fidelity Europe Capital Appreciation (FECAX) +35.55% +3.61% +3.27% 1.32%
ICAP European Select Equity Fund (ICEUX) +38.79% +4.68% +2.66% 0.80%
ICON European Region Fund (ICSEX) +39.66% +6.15% +1.76% 1.87%
Fidelity Advisor Europe Cap Apprec/A (FAEAX) +34.36% +1.95% +1.53% 1.69%
Fidelity Europe (FIEUX) +43.89% +0.35% +0.55% 0.98%
Vanguard European Stock Index (VEURX) +34.63% +0.12% -0.76% 0.32%
Excelsior Pan European Fund (UMPNX) +46.43% -1.76% -1.35% 1.39%

*Source: Standard & Poor’s. Total returns are in U.S. dollars and include reinvested dividends. Data as of 4/30/04.