Banking on the world

For mutual fund investors in the United States, thinking outside the borders has its rewards. Those who had their funds spread across a variety of domestic and international fund categories enjoyed solid results in the first quarter.

World equity funds, a broad category ranging from purely foreign funds to global offerings with a stake in the US, climbed 7.6 percent. Latin American funds added 15.9 percent in the quarter, while the category's outsized 59 percent annual gains over the past three years top all the domestic and international fund types, according to fund tracker Lipper Inc.

Other prominent gainers were funds that invest in China (up 20 percent), Europe (up 13.3 percent), and emerging markets (up 11.9 percent). With well over half of all net equity fund inflows swelling their coffers, world equity funds - now totaling some 2,000 entities - lay claim to over $1 trillion in assets. That represents almost one out of every five dollars of stock-fund assets.

Looking ahead, international fund managers expect foreign markets to continue to demonstrate resilience, although gains are likely to moderate from the robust first quarter. "The valuation gap that existed between developed markets in Europe and US equities has largely been closed," says Thomas Mengel, portfolio manager of the Ivy International Value Fund.

Business improvement is widespread across continental Europe, especially in Germany, where corporate profitability is increasing.

Several foreign central banks have been raising official interest rates, but at a gradual pace and from very low historical levels, Mr. Mengel says. Still, he believes there probably won't be as much of a disconnect between US market performance and European markets as there was in 2005, when the average European mutual fund climbed 12.3 percent.

US equities have significantly lagged major European stock indexes since the Federal Reserve began steadily hiking US interest rates two years ago. History suggests that the case for US stocks' outperformance would become more compelling if the Fed were to begin cutting rates, although it is premature to count on this scenario. An end to the Fed tightening cycle, nonetheless, would probably mean better relative US equity performance, analysts point out.

For many international fund managers, Japan is the developed market offering the most promise for the next year or two. Since diversified international funds typically have about one-quarter of their portfolios in Japanese securities, the resurgent economy represents an attractive long-term opportunity, says Ray Mills, portfolio manager of the T. Rowe Price International Growth and Income Fund. Last year's 40 percent run-up in the Nikkei Index gave many international funds a hefty boost, but Mills believes the Japanese bull market, now digesting some of its gains, has further to go.

"The troubled banking system has been cleaned up, government reforms have made companies more shareholder friendly, and China has become a thriving export market for Japanese products," Mr. Mills adds. "Deflation appears to be ending, and that has buoyed business confidence and spurred healthy consumer-spending growth." Because stocks represent only 11 percent of household financial assets, well below the "pre-bubble" period, a steady shift out of bank deposits and into equities could lend fresh support to the market, Mills says.

Looking at mutual funds overall, 2006 was supposed to mark the resurgence of large-cap stocks, especially growth-oriented issues.

With an economic slowdown in sight and monetary policy turning more restrictive, Wall Street strategists predicted that large-cap companies would begin to outshine their smaller rivals. Historically, small-cap stocks tend to fade in aging bull markets when interest rates rise and corporate profits flatten out. After an extended six-year run, small-cap stocks appeared ready to falter at the end of 2005. Moreover, valuations of large-cap stocks, especially in the technology, healthcare, and consumer durables sectors, looked beaten down, opening the door to bargain hunters.

So far, however, these forecasts have failed to come true. Instead of wilting, small-cap stocks sprang back to life in the first quarter. For example, small-cap growth funds scored the best gains among US diversified equity funds, soaring 12 percent. That was more than double the group's rise for all of 2005, according to Lipper Inc. " The smaller, the better was the watchword in the first quarter," says Don Cassidy, Lipper's director of fund analysis. "It's a sign that investors are less risk-averse than they have been in a long time."

Small growth funds capitalized on buoyant merger and acquisition activity, spurred by large pools of cash pumped into corporate buyouts by private equity funds. But large-cap growth funds, which hold triple the assets of small-cap growth funds, rose only 3 percent.

Although the stock market sagged a bit in February, in March several key stock market indicators reached highs not seen since the peak of the bear market rally in May 2001. As a result, more than 90 percent of the funds tracked by Lipper advanced. The average US diversified equity fund rose 6.7 percent, the best quarterly advance in more than a year.

Most active fund managers continued to outpace passive, index-tracking funds such as Vanguard's 500 Index Investors, one of the nation's 10 largest funds.

"When there are strong themes like energy, real estate, or emerging markets leading the way, active managers can jump aboard, but indexers can't change their weightings." says Mr. Cassidy. Since May 2001, index-fund investors have done little more than break even. Over the same period, more than 80 percent of equity funds showed gains after expenses of close to 35 percent.

Among sector funds, real estate funds were pacesetters, rising 13.8 percent. Investors in Real Estate Investment Trusts (REITs) - companies that manage portfolios of properties such as apartments, shopping malls, and offices - face a classic investment quandary, analysts say. In the short run, with vacancy rates shrinking and commercial real estate prices firm, the outlook appears favorable. But REITs, which must legally pay out 92 percent of their earnings as dividends, are traditionally valued in terms of dividend yield. REIT yields are already well below those of 10-year Treasuries, and the shares are considered vulnerable to a sell-off if interest rates move much higher.

Gold-oriented funds sparkled, advancing 21 percent as the price of the yellow metal hit a 25-year high. Although not for the cautious, gold funds can act as a partial hedge against inflation and a weakening dollar, analysts say.

Natural resources funds, up 11.9 percent, continued their three-year-long winning streak. Strength in these funds, which concentrate on energy-related stocks, reflect investor worries about tightening global oil supplies and a desire to own "hard assets" such as copper and timber, analysts say.