Why Are Europe Funds Down When Sentiment Is Up?

One week into August, the 2014 performance of certain international-stock funds raises a number of questions. Perhaps the most eye-catching figures come from the top- and bottom-ranked Morningstar Categories.

India Rising
The best performer in 2014 by far is the India-stock group, which has soared 27% for the year to date through Aug. 7. That's a stunning turnaround from 2013, when India funds, which only a few years earlier had struck many global observers as the most appealing emerging-markets play around, suffered an 11.2% loss. Among the 16 international-stock categories, only the Latin America group fared worse.

But while the magnitude of this year's India-stock rebound would have been difficult to foresee, the reasons behind the turnaround are clear. First, in September 2013, a new central-bank chief instilled some confidence and halted an alarming slide in the rupee. Second, investors were invigorated by the anticipation of a new government (which was duly elected earlier this year) led by a party viewed as being more pro-business than its predecessor and more willing to make needed economic and financial reforms.

There's no telling if the promised reforms will arrive or produce the intended effects. But given this background, the India market's rise and the India-stock category's top ranking are understandable.

The Europe Question
More puzzling is the category at other end of the spectrum. This year, one of the most amazing developments in global finance has been the recovery of many European stock and (especially) bond markets--particularly those in countries recently considered to be the most troubled. The perception that Europe's debt crisis has become less acute along with a return to positive economic growth--minuscule as the growth rates may be--have apparently impressed global investors. The MSCI Spain Index is up 6% in local-currency terms so far this year, and even the MSCI index for Italy, where disappointing economic numbers were released late last week, has risen 4%. Meanwhile, another major market, Switzerland, has gained nearly 4%.

So why is the Europe-stock category average down 3.7% through Aug. 7, the worst showing of all 16 international-stock categories?

One possible answer could be the Ukraine crisis. Russia's stock market has suffered steep losses this year, as has Poland's. Hungary has its own separate problems driving its market into the red as well. Alas, this explanation falls short. The handful of funds that focus on Russia or Poland alone, along with a few that target Eastern Europe more broadly, were removed from Morningstar's Europe-stock category in 2013 so they wouldn't distort the results of the group, which now includes only pan-Europe offerings. Perhaps these pan-Europe funds own enough Russian stocks to be causing pain? Nope--their average Russia stake is nearly zero.

Rather, the reasons for the Europe-stock category's weak showing this year appear to be more subtle. One issue: Funds typically don't have a substantial percentage of their assets in Spain and Italy. They own much more in the bigger stock markets of Germany, France, and the United Kingdom, and in local-currency terms those markets have been weak, ranging from a loss of 6% in Germany to roughly flat in the U.K.

Second, currency effects have played a role. When foreign currencies lose value against the U.S. dollar, that hurts returns for U.S.-based funds that don't hedge their currency exposure (that is, most of them). Although the British pound has gained a bit against the dollar thus far this year, that benefit was more than offset by Europe-stock funds' heavier exposure to the euro, which has weakened versus the dollar. As a result, the stock market returns for eurozone countries are lower from a dollar-based perspective (the relevant one for a U.S.-based fund investor) than in local-currency terms. The MSCI Spain Index's 6.0% gain, for example, falls to just 2.4% in dollar terms. Outside the euro area, the Swiss franc also has lost ground against the greenback in 2014, adding to the negative impact on fund returns.

A third reason for the Europe-stock category's woes could be more prosaic: There simply aren't many offerings in the group--only 25 separate mutual funds. In any small category, the performance of individual funds, driven by their managers' specific stock decisions, can affect the group average as much as overall trends. For example,  Franklin Mutual European (TEMIX) is an unusual fund with a deep-value bent. It has lost 5.7% so far this year, and the top of its portfolio reveals stock-specific culprits: Five of its 11 most heavily weighted holdings have suffered double-digit losses so far this year. Several have plunged more than 20%.

Buying Opportunity?
All that doesn't explain why the Europe-stock category lands in the cellar if other regions have similar stories to tell. But in addition to India, many emerging stock markets and currencies have rebounded this year, and Australia and Canada have shown healthy gains, too. That has helped broad-based international-stock categories beat pure-Europe funds. Many other categories focus specifically on emerging markets.

If India rose from near the bottom of the category rankings last year to the top this year, does that mean it's time to buy Europe, this year's laggard? It could be; some observers note that valuations are lower there, in general, than in the U.S. market.

But deciding to invest based on those facts alone would require quite a leap. For one thing, Europe funds haven't lost nearly as much as India funds did in 2013. (In fact, India funds' losses actually were much deeper at one point last year than the final tally shows, because they staged a fourth-quarter rebound.) Second, reversals of fortune from one calendar year to the next are not, of course, guaranteed.

Curiously enough, though, if the India-stock category ends 2014 on top of the international-stock rankings, it would mark the third-straight year that the worst or second-worst performer from one year ended up as the best performer the next. The second-worst international-equity category in 2012 was Japan, which then topped the charts in 2013. And the worst performer of 2011 became the best in 2012. That category? India stock.