Morningstar Year-End European Fund Research Report (2008)

gers. These include Lehman Brothers, Bear Stearns, Merrill Lynch, Washington Mutual, Fortis, Fannie Mae, Freddie Mac, Indy Mac, among others. It was also the year in which the notion of decoupling was proven to be unfounded. When western economies slowed, emerging economies felt their pain and posted enormous drops on the year. "Whilst there was some protection from the equity meltdown to be found in bonds, funds with substantial credit risk were hit hard, and so the cushion investors have come to expect from their bond funds was less than usual," said Christopher Traulsen, director of fund research for Morningstar Europe. The lone bright spot was government debt, which, as is usually the case in uncertain times, proved to be the asset of choice for skittish investors.

2008 was also a year in which currency exposures had a dramatic impact. With the Sterling depreciating sharply versus the Euro, Dollar, and Yen, unhedged funds with exposure to any of those currencies received big boosts that helped cushion the blow of otherwise dismal returns.

With assets falling, major fund firms have come under pressure. Fund liquidations and mergers increased relative to fund launches, and layoffs mounted. "Consolidation of funds and firms has already begun, and we expect the trend to continue in 2009," Traulsen said.

Equity Funds
Equity funds in 2008 offered few places to hide. Major stock markets around the globe plummeted, with investors shunning risk across the board. This can be seen in the underperformance of small- and mid-cap funds relative to their large-cap rivals, and in the relative strength of funds heavily weighted in defensive areas such as healthcare and consumer goods, which includes many consumer staples issues. Growth funds, which carry more price-risk than funds in other peer groups, slightly underperformed compared to value and blend offerings. The slowdown also precipitated a huge fall in overheated commodity prices, badly hurting funds exposed to energy and natural resources.

Sector Equity Funds
Financial Services Major Victim, but Biotech and Healthcare Funds Fared Well
"Sector funds have limited uses in our view. They are extremely volatile, often duplicate exposure an investor has elsewhere in a portfolio, and can be difficult to manage effectively given the cash inflows and outflows they attract," Traulsen said. "However, they can provide a useful snapshot of larger economic trends." In 2008, the worst-performing sector equity category was Morningstar Sector Equity Financial Services, down 55.37%, reflecting the cataclysmic events in the industry. In this group, funds that had less exposure to banks and investment banks fared better than their rivals. For example, Hiscox Insurance Portfolio and the Eurizon EasyFund Equity Insurance Fund both delivered smaller losses than the norm. Some managers also used defensive moves into cash and bonds to shield their portfolios, most notably Philip Gibbs at Jupiter Financial Opportunities, which finished the year up 7.47% in GBP terms (down 22.38% in USD terms). The Morningstar Industrial Materials category, which includes natural resources funds, fell 52.11%, and the Morningstar Energy category fell 47.42%, reflecting the broad downturn in commodity prices during the year. Funds focused on real-estate securities globally and in Europe also suffered big losses, falling an average of 48%.

The strongest sector funds in 2008 were focused on those areas of the market that have historically displayed defensive characteristics. The Morningstar Biotechnology category fell 21.24%, while the average fund in the Morningstar Healthcare category fell 26.71%.

European Equity Funds
Emerging Europe and Norway Funds Hit Hard as Commodities Slump
For equity fund investors, there was little to no respite from the global meltdown in 2008. Regional performance was poor across the board, but economies heavily dependent on energy and other natural resources were among the hardest hit as oil fell by more than 50% and industrial metal prices slumped sharply.

The Morningstar Russia Equity category was the worst performer of the year, ending 2008 down 74.89%. The average Russian equity fund held more than a third of its assets in energy at year end and another 23.5% in industrial materials, where many issues are energy or resource related. In addition to energy exposure, political risk became a factor for Russian funds as Russia invaded Georgia and concerns rose around Russian Prime Minister Vladimir Putin's aggressive remarks concerning nickel miner Mechel. Other notable poor performers caught up in the slump included funds in the energy-heavy Norway Equity category, down 63.71% on average, and funds in the Emerging Europe and Emerging Europe ex-Russia categories, down 68.03% and 63.57%, respectively. The average Norway equity fund devoted 36% to energy and 22% to industrial materials according to Morningstar's holdings data, while Emerging Europe ex-Russia funds were heavily exposed to financials issues, with an average weight of 42% in the sector.

Swiss and Spanish Equity Funds Show Resilience
Among Europe-focused equity funds, offerings in the Morningstar Switzerland Large-Cap Equity and Switzerland Small- and Mid-Cap categories showed the most resilience, with losses of 31.62% and 37.91%, respectively. The funds were helped by currency translations, as the Swiss Franc appreciated relative to the Pound and Euro in the period. However, their exposure to healthcare and consumer staples also helped: According to Morningstar's holdings data, the average Swiss Large-Cap Equity fund held 33% in healthcare issues, 23% in consumer goods, and just 0.4% in the beleaguered energy sector.

Spanish equity funds also fared better than the norm, falling 41.1% in 2008. This relative strength was surprising considering that Spain is one the European countries most affected by the housing bubble. "Several factors helped shore up the market," said Fernando Luque, Senior Financial Analyst for Morningstar Spain. "First, the Spanish financials sector performed better than the broader European group. Second, Spanish telecommunications company Telefonica held up reasonably well, losing just 29%. Telefonica is a major holding for many Spanish equity funds given its prominence in local benchmarks." Spanish funds also tended to hold more cash than other groups in the period, lending them further resilience.

UK Equity Funds Hurt by Financials, Mid-Caps, and Commodities
UK equity funds followed broader market trends. Although large-cap UK equity funds tend to be heavily invested in financial services and energy, they still outperformed funds in the UK Mid-Cap/All-Cap Equity and UK Small-Cap Equity categories as investors shunned liquidity risk, perceived or otherwise. The average UK Small Cap Equity fund fell 56.29% in 2008, followed by the average UK Mid-Cap/All-Cap Equity fund, with a loss of 52.99%. Funds in the Morningstar UK Large-Cap Growth category lost a bit more 51.41% than other UK large-cap offerings as they had more exposure to price risk (giving them further to fall when the optimistic scenarios implied in the valuations proved to be far from true) and to commodity-related equities relative to UK Large-Cap Value and UK Large-Cap Blend funds.

These trends can also be seen by looking at the top and bottom 50 funds for the year across the Morningstar UK Large-Cap Equity categories. Morningstar's holdings data show the top 50 funds in the three Morningstar UK Large-Cap Equity categories held an average of 74% in large-caps, compared to 60% for the bottom 50 funds. In contrast, the bottom 50 held 16% in small-caps, compared to 6% for the top 50. The top-performing funds were also overweight compared to the bottom 50 in defensive sectors including healthcare (9.9% vs. 5.2%), telecommunications (9.9% vs. 8.0%), consumer goods (10.2% vs. 5.4%), and utilities (9.8% vs. 4.2%).

As with UK equity funds, broad regional Europe Equity funds tracked investors' shrinking appetites for risk - the Europe Small Cap Equity category was the worst performing of the five Morningstar Europe Equity peer groups, down 52.92%. Funds in the Morningstar Europe Mid Cap Equity category fell 49.14%. Large-cap funds performed better, but the growth/value distinction had less of an impact than it did elsewhere: Europe Large Cap Value funds lost 46.09% on average, whilst Europe Large Cap-Blend and Europe Large-Cap Growth funds lost 46.08% and 45.64% respectively. The salutary effect of higher exposure to healthcare in the blend and growth groups likely helped give them a slight edge.

Asian Equity Funds
2007's Winners Become 2008's Losers
Asian equity markets fell along with their western peers, creating a bleak picture for 2008. For the quarter, the average fund in the broad Morningstar Asia-Pacific ex-Japan Equity category lost 21.29%, whilst the Asia-Pacific with Japan Equity category fell 16.73%. In 2008, the average fund in Morningstar's Asia-Pacific ex-Japan Equity category and Asia-Pacific with Japan Equity category lost 51.98% and 43.40%, respectively.

These trends can also be seen by looking at the top and bottom 50 funds for the year across the Morningstar UK Large-Cap Equity categories. Morningstar's holdings data show the top 50 funds in the three Morningstar UK Large-Cap Equity categories held an average of 74% in large-caps, compared to 60% for the bottom 50 funds. In contrast, the bottom 50 held 16% in small-caps, compared to 6% for the top 50. The top-performing funds were also overweight compared to the bottom 50 in defensive sectors including healthcare (9.9% vs. 5.2%), telecommunications (9.9% vs. 8.0%), consumer goods (10.2% vs. 5.4%), and utilities (9.8% vs. 4.2%).

Chinese equities, underpinned by a stunning RMB 4 trillion stimulus package unveiled in early November, became outperformers in the region in the fourth quarter, but slowing export growth and natural disasters dragged their performance in 2008. The average China equity fund lost 52.88% in 2008. Meanwhile, with a deep loss of 27.92% in fourth-quarter 2008 and 63.63% for the year, the average fund in Morningstar's India equity category lagged its Asian peers throughout 2008. "The global economic slowdown hurt, and the tragedy in Mumbai sparked investor fear of political risk in India and in Asia more broadly," said YT Kum, fund analyst for Morningstar Asia.

In mid-2007, many managers of Asian equity funds tilted away from Chinese and Indian equities for valuation reasons. This move was vindicated in 2008, as stocks in these countries plummeted amid the global market rout. Chinese and Indian equities now trade at a discount to the broad Asian region. However, attractive valuations did not entice value-oriented managers. In the fourth quarter, many portfolio managers of Asian equity funds and Greater China Equity funds added Hong Kong equities, but remained cautious on Chinese and Indian equities.

A brutal unwinding of carry trades and a 26.9 trillion yen economic stimulus package fuelled the Japanese yen's appreciation against the U.S. dollar over the quarter. However, currency appreciation could not offset the fact that Japanese economic fundamentals are deteriorating - flagship large-cap exporters such as the automakers and Sony slashed their profit forecasts due to depressed Western demand. This led to an exception to the broader global trend of small-caps underperforming as the Morningstar Japan Large-Cap Equity category lost 33.16% and the Japan Small/Mid-Cap Equity category lost 28.65% in 2008. The performance was considerably worse in local currency terms, but Dollar investors in unhedged funds were able to benefit from the Yen's appreciation relative to the USD.

Bond Funds
Bond funds, regardless of their currency focus, shared a common trait globally: Credit risk was shunned and safety was sought. Across the board, the Morningstar High Yield Bond categories were the worst performers in their respective currency groupings. Corporate Bond categories were also hit hard while the Government Bond categories fared the best. The Morningstar Dollar High Yield category fell 27.16% and Dollar Corporate dropped 8.38%, while the average Dollar Government fund gained 3.92% in the period.

Industry Trends
Fund Consolidation on the Rise
The market downturn has badly cut assets under management in the industry, and fund firms are responding by paring back fund line-ups, cutting jobs, and undertaking mergers with other organisations. Large fund houses such as Fidelity have been affected right along with small firms such as New Star, a boutique UK house that is on the ropes after high levels of risk embedded in its funds led to dreadful losses.

The rate of fund obsolescence shows the pattern starkly. According to data collated by Morningstar, in 2006, 7,299 new share classes were launched into Europe, while just 1,483 were shut down or merged with others. In 2007, new issuance was fairly steady at 7,445 new classes, and closures reached 3,325. In 2008, however, new issuance dropped 18% to 6,132 new classes, and liquidations and mergers soared to 4,538 - a 36% increase in closures over 2007, and a 206% increase over 2006.

"The numbers are dramatic, but a rationalisation was long overdue," Traulsen said. With the advent of cross-border fund sales under UCITS has come increased competition for assets under management. Instead of competing on quality and price, however, asset managers have responded in part by filling out their line-ups with every conceivable type of fund, including many narrowly focused "hot-dot" funds, and aggressively marketing them. "This kind of thing often ends badly, as those who bought into Russia, China, energy, or property funds are now finding, for example," Traulsen said. "Indeed, if the current downturn has any silver lining for fund investors, it may be that it reduces the industry's orientation toward sales and marketing and refocuses asset managers on delivering quality investments where the have a clear ability to add value."

About Morningstar, Inc.
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About Morningstar Asia
Morningstar Asia was established in April 2000 and has expanded its businesses into Japan, Korea, India, Mainland China, Taiwan, Singapore and Hong Kong. Morningstar Asia not only offer timely information on mutual funds, but also insightful analyses, unbiased fund ratings, and sophisticated analytic tools to help both individual and professional investors make more intelligent investment decisions. Morningstar Asia does not own, operate, or hold any interest in mutual funds, stocks, or insurance products, ensuring its independence and objectivity.

Notes to Editors:

The analysis contained in this report is based on an assessment of all European open-ended funds tracked by Morningstar. The company tracks approximately 60,000 European open-end funds.

Performances are based on the latest available data as of Dec. 31, 2008. Data tables are below.

The Morningstar Quarterly European Fund Research Report is written by the company's team of European and Asian fund analysts. Morningstar employs more than 220 experienced and qualified researchers and investment analysts globally, with 28 based in Europe, and has published detailed analysis on more than 4,000 funds and stocks worldwide. The company's reputation for independence is driven by its "investors first" mission to create great products that help investors reach their financial goals. Morningstar does not charge fund companies to issue qualitative opinions on their funds, and analysts have complete freedom to state an opinion, positive or negative, on any fund they cover. The company's analysts base their opinions on their individual comprehensive analysis of fund holdings and performance data, interviews with portfolio managers and key fund group executives, and proprietary analytical tools.

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