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Count to 10 Before Betting on a Europe Rebound

Greece, Portugal, and euro woes may tempt contrarians, but issues abound.

Gregg Wolper, 05/05/2010

Greece's financial travails have been making headlines for several months now. Lately the economic woes of Portugal and a few other European nations--most notably Spain--have pushed them into the spotlight as well. Their bonds have fallen in value. The euro is suffering. Stock prices in many European markets are also feeling the pain.

Such overwhelmingly negative news often prompts canny investors to think of ways to benefit. To take the contrarian path. After all, you don't have to be Warren Buffett to know that juicy opportunities can arise when others are running for the exit.

But that doesn't mean you should rush to buy a Europe-stock fund. For one thing, most of the region's stock markets haven't fallen all that far, and the euro isn't even close to its historic low. Further declines are hardly out of the question. Second, even if you've decided the pessimism is overblown and are inclined to jump in, making such a play isn't a simple task. As with any other investment, it makes sense to investigate before buying.

The following is far from a comprehensive list of factors to consider. But if you're thinking of investing in a Europe fund as a contrarian move, here are a few things to keep in mind.

1. You may already have substantial exposure to Europe. Funds in the foreign large-cap categories tend to have huge weightings there. The average is roughly 60%, and for some portfolios the figure is higher. Templeton Foreign TEMFX, for example, had about two thirds of its assets in Europe at the end of February 2010, and on March 31, Causeway International Value CIVVX was stashing more than 70% of its assets there.

2. By and large, Greek and Portuguese stocks play almost no role in international funds. That's true even for those funds that specifically target Europe. At the end of March 2010, for example, T. Rowe Price European Stock PRESX had just 1% of assets in Greece and 0.3% in Portugal. Those numbers are typical of other pan-Europe funds, though a few had a tiny bit more in Greece.PAGEBREAK

3. By contrast, Spain weightings in Europe-stock funds vary widely. BlackRock EuroFund MDEFX had just 2% of assets in Spain in its March 31 portfolio, while T. Rowe Price European Stock had more than 10% in Spain at that time.

4. A continued fall in the euro will be a negative when Europe-stock fund returns are translated into dollar terms for U.S.-based shareholders, but a further decline in that currency wouldn't be all bad from an investor's perspective. Exports play a big role in the fortunes of many European companies, and a weak euro makes the goods and services of eurozone companies more attractive to potential buyers outside of that zone.

5. Don't assume that even an unhedged Europe-stock fund will provide full exposure to a potential euro rebound down the road. In fact, half the weighting of the MSCI Europe Index consists of countries that do not use the euro (the United Kingdom, Switzerland, Sweden, Denmark, and Norway). Those other European currencies sometimes move more or less in line with the euro, but on occasion--as in 2010--there can be sharp differences.

6. If you're hoping to cash in on a rebound in the euro, don't buy Mutual European MEURX. This is one of the most appealing Europe-focused mutual funds, with a value-oriented approach that has worked well at other Mutual Series funds over the years. But unlike most Europe funds, it hedges a large portion of its foreign-currency exposure into the U.S. dollar. That helps returns for U.S. shareholders when European currencies fall, but has the reverse effect when those currencies strengthen.

7. More-targeted plays are available in the exchange-traded arena, but those too have traits that render them less than ideal. For example, iShares MSCI EMU Index EZU does focus exclusively on the eurozone, but 56% of its assets are invested in France and Germany. Only 1.2% is in Greece, and even less in Portugal. IShares MSCI Spain Index EWP provides full exposure to the country in its name, but watch out: Fully 41% of that portfolio sits in just two stocks (Banco Santander and Telefonica).

8. Until recently, a closed-end fund known as Spain Fund SNF also would have offered targeted Spain exposure, but a few months ago it broadened its focus. Now called The Ibero-America Fund, its Spain weighting was down to 83% of assets at the end of February, with the rest devoted to Mexico, Brazil, and Portugal. Less than 1% was in Portugal. (And the fund's 2009 expense ratio was a sky-high 1.99%.) There are no ETFs, closed-end funds, or mutual funds devoted specifically to Portugal or Greece.

9. Remember that the returns of the Europe-stock category provide only an imperfect indicator of how "Europe" is faring. That fund group includes not just pan-European funds, but also a handful of specific Russia/Eastern Europe offerings, along with some small-cap specialists and other narrowly focused portfolios--all of which can skew the category averages. That's happened in 2010: Through April 30, Vanguard European Stock Index VEURX (a large-cap fund that doesn't include Russia or Eastern European markets) is down 4.2%, and nearly all other pan-Europe funds lie in a tight range around that figure. But buoyed by huge gains in the Russia/Eastern Europe funds as well as a few others with special mandates, the overall category shows a mere 0.6% loss.

10. Finally, the above points are aimed at investors thinking of investing in stock funds. But it's safe to say that trying to make a play on the fixed-income side also would involve numerous complexities--some of them very different from the ones cited here. So it would make sense to tread even more carefully in that realm. 

Gregg Wolper is a senior analyst with Morningstar.

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