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Patient Investors Rewarded Overseas

Jeremy Glaser
Shannon Zimmerman

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Investors have continued to pull money out of international-stock mutual funds, but for the ones that have stayed, how have they fared? I'm here with Shannon Zimmerman. He's an associate director of fund analysis at Morningstar. We're going to take a look at some of the performance.

Shannon, thanks for talking with me today.

Shannon Zimmerman: Good to be with you, Jeremy.

Glaser: So, let's talk a little bit about how those international funds have done so far in 2012.

Zimmerman:Well, as with the U.S. markets, international markets have largely done well. We have no international-stock fund categories that are in the red so far this year. We have some that have done quite a bit better than others. I'm going to talk about those. If you look at what have been the performance drivers among our diversified international categories, it's been better to be in smaller-cap funds rather than large, it's been better to be in growth-oriented funds rather than value-oriented funds.

Actually, we saw a little bit of growth trumping value on the U.S. side earlier this; that's kind of dissipated. But the market-cap dynamic is quite a bit different. On the U.S. side, large cap has been the sweet spot for the market, whereas internationally it has been the small- and mid-cap categories. In fact, foreign small-mid growth that's been the number-two category by performance so far this year and a typical fund in that category is up about 18%.

Glaser: Looking at the international categories then, what's performed the best so far?

Zimmerman: Well, India equity has been the best-performing international-stock fund category, but it's a tiny category with about only 12 funds, the last time I looked, which is really about 15 minutes ago. All of them are up pretty substantially, so a solid performance in absolute terms. The top performer in that category is a Goldman Sachs fund, Goldman Sachs India Equity, up about 33%. And one at the end of that list, the 12th of them is a Franklin fund, Franklin India Equity, which is up about 16%. So, still even at the bottom of that list, that's quite a nice return.

Places in the international markets that have not done so well are Latin American stock and Japan stock. Both of those categories are positive on the year, but the Japan-stock category is up only about 2% and Latin American stock is up less than 6%.

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Glaser: Let's talk about Europe a little bit. Certainly, it seem like earlier this year all we could talk about was the European sovereign debt crisis.

Zimmerman: Have we stopped talking about that?

Glaser: Briefly, but I think that's going to come back very, very soon.

Zimmerman: I think that's right.

Glaser: We see that as maybe a disconnect between what's happening with European-stock funds and what's happening with the fundamentals of the European economies. What have you seen there?

Zimmerman: Well, it's interesting. You framed it exactly right. There is a disconnect between what's going on in the equity markets versus what's going on in the European economy. [On Nov. 7], the EU officials came out to sort of discount their earlier forecast, what they were expecting this year and next. Whereas the earlier forecast was for year-over-year flat GDP nongrowth, I guess, now, they are actually forecasting that GDP in the eurozone countries will decline by about 0.3%. So in recession for the eurozone.

Next year, they are not in recession, but the markdown is even more substantial. Whereas they were earlier expecting about 1.4% in GDP growth, now it's a paltry sum of about 0.3% again, but on the positive side for 2013. We'll see if even those forecasts turn out to be perhaps too rosy given what seems to be this intractable problem that's been simmering for; what, 18 months, 24 months now almost.

Interestingly though, the dynamic in the equity markets in Europe is quite a bit different. In 2011 we saw a lot of baby-with-the-bathwater selling, I think it's safe to characterize it as. We had sturdy companies with rock-solid fundamentals and plenty of prospects for growth and huge swaths of market share as it was, marked down with everything else on generalized concerns about the state of the European economy. That's largely reversed. And so, a typical fund in our Europe-stock category is up about 15% so far this year and it is placed at number five. We have 15 international-stock fund categories, and the Europe-stock category ranks number five among them with the 15% return on the year; pretty impressive.

Glaser: So, that divergence of the performance of the stocks with the performance of the economies, what's that meant for flows? Are investors betting on Europe now?

Zimmerman: No. So, that's an excellent question. So, while managers of the mutual funds that target European companies are making a bet on Europe or are feeling more comfortable about going into European companies, fund investors are not, at least on the mutual fund side, and this is if you look at flows into both actively managed vehicles and passively managed vehicles. The Europe-stock category remains in net redemptions.

Now, it has abated somewhat. In 2010, the category lost about $8 billion in shareholder redemptions. In 2011 it lost about $1.5 billion. This year it's $800 million in redemptions. Still in that redemptions, but the trajectory at least is looking less ugly, I guess, I would say. But yeah, fund investors are still shying away, largely on headline-risk news, I think. Every time you open the business pages, you are reading about the woeful state of the European economy. But fund managers, particularly those of the value persuasion know that volatility creates opportunity, and if you want to find bargains, sometimes you have to look at the bottom of the barrel. And if you find solid companies that have characteristics that I was just mentioning, that have been marked down because of concerns that are really kind of ancillary to their core business, that can be a wonderful opportunity to find bargains.

David Herro at Oakmark International has an overweight to Europe right now, a pretty substantial overweight. About 55% of that fund's assets are in Europe versus a category norm of about 33%, and he's a big bet--and he would never call it a bet because nothing they do there is top-down, it's always "We've backed into our industry and sector weights." He has a big allocation, I should say, to commercial banks.

Glaser: That's certainly interesting because financials seem like they would be the most exposed to a potential eurozone crisis or continuation of the crisis. Are other managers also finding value in banks, or are they mostly sticking to this consumer names?

Zimmerman: Well, so, Herro has pretty substantial overweight. So, most managers are not doing what it is that he is doing, but just to stick with that fund for a second because I think it is a good example of how if you do your homework right, you can navigate tricky terrain and have some pretty nice returns as a result of it. So, even though he does have that overweight to commercial banks and to financials in general, it's high-quality stuff. So it's Credit Suisse; it's not some of the more rickety banks that may fall victim to the eurozone's crisis.

Glaser: Well, Shannon, thanks for your update on performance. And we look forward to talking to you soon.

Zimmerman: Good talking to you, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.