SUBMERGING MARKET FUNDS DRY THEIR FEET: U.S. OFFERINGS TAKE BACK SEAT

All the hype over the fortunes of the Dow Jones Industrial Average has overshadowed a rally that could have more far-reaching implications.

Fledgling recoveries in Japan and some emerging markets, including Latin America, are breathing new life into many long-suffering international stock funds.

Since last July, assets in international and global funds have plunged 9% to $422.4 billion, according to Boston-based Financial Research Corp.

But the bloodletting may soon be stanched. Funds in Lipper Inc.’s world equity category — which includes global, international, emerging markets and regional offerings — have outperformed their U.S. counterparts so far this year.

Through March 18, general equity funds gained 1.74%, while world equity funds rose 2.26% — with Japan, Latin America, Canada, emerging markets and Pacific region funds leading the way.

That marks a reversal from 1998, when general equity funds were up 14.56%, compared to a mere 3.69% gain for world equity funds.

The rallies in Japan and emerging markets are paying off grandly for some international funds that didn’t follow the herd into Europe, where markets have slowed since the summer (InvestmentNews, Jan. 25).

Meanwhile, some funds that have loaded up on European stocks are scrambling to sell off portions of those holdings so they can ratchet up their exposure to Japan, which is up 11.21% for the year. Some are also tiptoeing back into Latin America and other emerging markets.

“A lot of portfolio managers were underweight in Japan and when Japan made a big move some of them freaked out and decided to bring up their weighting in Japan,” says David Lui, manager of the $110 million Strong International Stock Fund.

He, too, has sold some holdings in Europe to buy Japanese stocks, although his 10% weighting in Japan is still below the Morgan Stanley Capital International Europe Australasia Far East index, which has 23%. Europe now accounts for about 80% of the fund, down from 94.5% last October.

“The bottom line is that what we saw in August and September of last year was the point of maximum pain in emerging markets,” says Steven A. Schoenfeld, principal head of international equity strategies for Barclays Global Investors, the San Francisco-based asset management division of Barclays PLC.

“Any fund manager or investment adviser who totally abandoned emerging markets probably did a disservice to their clients and should consider reallocating some portion of their overall portfolio to emerging markets,” he says.

So far, so good but…

Of course, it’s still too early to tell whether the rallies — prompted in part by interest rate cuts, corporate restructurings and a wave of stock purchases by institutions — are sustainable.

Some fund managers point out that the Japanese market tends to rally in the spring — March 31 marks the end of corporate fiscal year and the tax year — but typically fizzles by the summer.

“You rush in only to see the bottom fall out in the second and third quarters,” says Ram Kolluri, chief investment officer of Global Value Investors Inc. in Princeton, N.J.

“I don’t mind missing the bottom. I’d like to see some real earnings evolving and some real demand developing. My models are still suggesting Japan as a wait-and-see.”

What’s more, some managers fear that interest rate hikes intended to curb Brazil’s budget deficit will lead to a recession there, dragging down neighboring countries that have been riding the coattails of its stock market recently.

“If you have Latin American funds you’d better sell them now,” says Strong’s Mr. Lui. “I have no confidence in that region.”

Indeed, investors aren’t rushing back into international funds at the first sign of improvement. Outflows from international and global funds actually worsened last month, $5 billion, vs. $165 million in January, according to FRC.

International funds, which don’t invest in the United States, suffered the worst net redemptions, $1.9 billion. Japan was a bright spot, with inflows of $17 million in February and $3 million in January.

Although flows tend to lag performance, international markets must beat the United States on a broader basis before fund shops hurt by last year’s global turmoil begin to recoup, says A. Michael Lipper, chairman of the New York fund tracking firm.

“A lot depends on when we see a significant differential in performance between the United States and large segments of the international markets,” he says. “That hasn’t really happened yet, but it looks like it is going to happen.”

Maybe so, if the Oakmark International Small Cap fund is any indication. Last year the $64.4 million small-cap value fund, managed by David G. Herro and Michael J. Welsh, bled assets as competitors that had piled into richly valued European stocks saw assets flood in.

“There were days when we would have a redemption,” says Mr. Welsh, “and David would try to find money in his own portfolio to put in.”

Mr. Herro may not have to dip into his pockets again this year.

The fund’s contrarian bets on emerging markets, Japan and the United Kingdom have begun to pay off nicely. With performance starting to rise from the ashes in the fourth quarter, it is the second best-performing international small cap offering, up 23.32% through March 19, vs. a mere 5.45% for its peers, reports Standard & Poor’s Micropal.

“Things have stabilized and turned up a bit. If you look at some of the places our competitors are overweight, especially Continental Europe, things haven’t gone all that well there lately,” says Mr. Welsh.

That’s prompted the Federated International Small Company Fund to cut its holdings in Europe to 49%, from 78% last September, and move more aggressively into the Pacific Basin, which now accounts for almost 40% of the $450 million fund. Japan represents about 16% of that, says manager Tracy P. Stouffer.

The Federated fund has moved into Latin America to a lesser degree. It has 4.57% of its holdings in the region, vs. 0.19% as of last September. Brazil’s market, notes Ms. Stouffer, has been fueled in part by privatization of large companies, which has made it difficult for small company funds to participate in the rally.

up 10.52% this year

The fund gained 10.52% through March 19, making it sixth in its category, according to Micropal.

“While Japan continues to look ugly from the macro side, on a micro level I feel it is recovering nicely,” says Ms. Stouffer, adding that an end to panic selling has helped emerging markets to recover. “With so many breaks in the market last year, whoever wanted to be out is out.”

Financial planners who have urged their clients not to abandon international markets are cautiously optimistic.

“We were probably in (international markets) too much in the last two to three years, much to the chagrin of many clients,” says Michael Ross, president of Financial Connection Inc., which manages about $20 million in New York.

Mr. Ross, who believes the U.S. market is overvalued, prefers to play the international arena through diversified funds, although his picks include the Japan Fund and Templeton Developing Markets.

Japan, he figures, has almost nowhere to go but up.

“I’m not completely down on some of the emerging markets funds,” he adds. “I don’t think long term the party is over for them. It’s volatile, but those are economies that are still continuing to grow at tremendous rates despite all their so-called problems.”