What's the Best Way to Invest in Europe?

It's not news that emerging markets have been hot in recent years, fueled by explosive growth rates and high commodity prices. The boom has even given us "BRIC" (referring to Brazil, Russia, India, and China), the most overused investment acronym since "TMT" (technology, media, and telecommunications).

Less covered has been the incredible rise of Europe, a region many were essentially writing off just a few years ago. The MSCI Europe Index has climbed 25% per year, on average, for the trailing three-year period. That's not too far behind the gains posted by emerging markets. Mutual funds in the Europe-stock category have been on fire, outdistancing all but a handful of other fund groups.

We've been getting an increasing number of calls about investing in Europe lately. For that reason, we thought this would be the perfect time to take a closer look at the region, the reasons behind its rally, and the best way to get Europe exposure.

Europe's Bull Run
For U.S. investors, the dollar's decline versus European currencies has dramatically boosted European equity returns. If you own a mutual fund that takes your U.S. dollars and uses them to buy stocks denominated in euros, pounds, Swiss francs, or Swedish krona (or even U.S.-listed versions of those stocks), the fund's portfolio gains in value when those currencies appreciate, so long as the fund is not hedging its currency exposure. Roughly 5 percentage points of the MSCI Europe's gain over the past three years comes from currency, and it has played an even bigger role over the trailing five-year period.

But the story doesn't end with currency gains; there are more fundamental drivers of European stock gains. First, many of Europe's largest companies are global players and their success reflects global factors, such as high oil prices. These days, where a company is headquartered can be incidental. Then there are factors specific to Europe, such as low interest rates, which have spurred economic growth and business activity. Low rates have also helped foment cross-border mergers and acquisitions, such as Italian bank Unicredito's purchase of German HVB, French spirits company Pernod Ricard buying the British Allied Domecq, and the frenzied jockeying for Spanish utility Endesa and Dutch bank ABN Amro. Competitiveness has improved, too, in many cases. Just like their U.S. counterparts, lots of European companies have restructured, automated, outsourced, and offshored their way to higher profits.

Eastern Europe is another factor. The European Union has expanded in the past few years to include several former Communist countries, notably Poland, Hungary, the Czech Republic, Romania, and Bulgaria. Western European companies have in many cases located manufacturing and back-office operations to these lower-cost countries. Western European companies such as banks and retailers have benefited from Eastern Europe's growth.

Eastern Europe has had an even more direct impact on the Europe-stock category's stellar returns. There are several funds in the category that focus solely on those emerging markets, the largest being  U.S. Global Accolade Eastern Europe . That fund, and others like it, have posted some of the biggest five-year numbers in Morningstar's entire fund database. Not only do those funds invest in the new European Union entrants, but also in Russia, which has boomed thanks to high commodity prices. A handful of dedicated small-cap funds have also been turbo-charged, as European small caps have soared, like their U.S. counterparts.

Will Europe Continue to Shine?
The short answer is "who knows?" Hot markets and hot fund categories often cool off. It's instructive to remember that in the late 1990s, the U.S. market was soaring, the dollar was strong, and some were writing off Europe, and the Euro currency, as failures. European stocks still look cheaper than their U.S. counterparts by most metrics, but they have advanced.

It's also very possible that the same engines that have boosted Europe in recent years could lose steam. Interest-rate hikes could damp business activity, M&A activity could slow, and corporate restructurings and Eastern Europe could recede as drivers of corporate earnings. Global trends could turn against key European companies. Some exogenous shock could occur, or investor sentiment could change. In short, trying to predict which region will outperform in the next few years--or which way currencies will go--is a tough game to play.

A Look at Europe Funds
Before plunging into a Europe-focused fund, consider that you probably have more Europe exposure than you think. The typical foreign large-blend fund devotes nearly two thirds of its assets to European stocks. Even foreign funds such as  Dodge & Cox International Stock (DODFX) and  Artisan International (ARTIX), which pay more attention to Asia and Latin America at Europe's expense, still invest more than 50% of portfolio assets in Europe. What's more, some domestic funds invest in European companies, as stock research has become more globalized and fund managers chase overseas returns.  Fidelity Capital Appreciation (FDCAX), for instance, has nearly 20% of assets in European stocks.

Those looking for dedicated Europe plays have few good options. For mainstream exposure, the best bet is  Vanguard European Stock Index (VEURX), which also has an  ETF share class (VGK). That fund tracks the MSCI Europe Index, providing exposure to Western Europe's giants for a bargain-basement price. For more distinctive exposure, broker-sold  Mutual European (TEMIX) is an intriguing option. The Mutual Series team has a distinctive value-based style that produces portfolios filled with off-the-beaten path names and sometimes distressed debt and merger-arbitrage plays. Be aware, though, that Mutual Series hedges most of its currency exposure in order to damp volatility, which holds back returns when European currencies strengthen.

Other mainstream funds in the Europe-stock category, such as  Putnam Europe Equity  and  T. Rowe Price European Stock (PRESX), have had a tough time overcoming their fee handicap and beating the Vanguard index-tracker. Fidelity's two Europe funds have at times provided some off-the-beaten path Europe exposure at an attractive price. But both  Fidelity Europe (FIEUX) and  Fidelity Europe Capital Appreciation  have seen inordinate manager and strategy change over the past several years. Neither is very attractive now.

There are 21 Europe-focused ETFs in Morningstar's database, making Europe-stock one of the biggest ETF categories. The single-country vehicles tend to be extremely top-heavy (iShares MSCI Belgium (EWK) has 25% of assets in its top holding), and the other ETF choices are of little use. Why, for instance, limit a portfolio only to companies domiciled in countries that use the euro currency, as does  iShares MSCI EMU Index (EZU), to the exclusion of the United Kingdom, Switzerland, and Sweden? Why stick just to the biggest companies on the continent, as does  DJ Euro Stoxx 50 ETF (FEZ)?

The risk of buying into an asset class that has enjoyed a five-year rally is one reason to avoid the Eastern Europe funds in the category, as well as the coming onslaught of Eastern Europe ETFs. Other reasons for caution include the fact that Eastern Europe funds tend to be quite concentrated and have lots of exposure to red-hot Russian energy stocks. We'd also think twice about buying a European small-cap fund at this point.

The fact is that most U.S. investors have already enjoyed the fruits of the Europe boom through their core foreign fund. Investors tempted to load up on Europe at this point--especially its hottest subareas--should remember that they can't buy yesterday's returns.