What to Make of the Top International Funds of 2006 in US

This year will end in a few weeks, and the lists of the best-performing funds of 2006 will be released soon thereafter. Morningstar US research team has provided some early insight into ....

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This year will end in a few weeks, and the lists of the best-performing funds of 2006 will be released soon thereafter. Morningstar US research team has provided some early insight into which funds are likely to make the 2006 international leaders'list and to make sure investors don’t allow the recent rewards of such funds to obscure their substantial risks. Such analysis is intriguing as "Chinese fever" keeps burning among Hong Kong investors.

China Funds Are Leaders Of The Emerging-Markets Funds' Domination
Geographically focused and other daring funds usually lead the calendar-year rankings of international funds, and that has certainly been the case in 2006. Given the sheer number of emerg

ing countries and the overall enthusiasm about the developing world, several single-country emerging-markets funds make this year’s international leaders'board. First among equal, China funds are taking the lead: Eight China funds in US rank among the 10 highest-returning international funds for the year to date through Nov. 30; two others rank among the top 25; all 10 of these funds are up more than 37%.

Not only China, several other single-country emerging-markets funds also record enticing returns. For instance, ING Russia and Eaton Greater India have soared more than 50% and 30% respectively for the year to date through Nov.30.

However, their commitment to a single emerging market is a two-edged sword. There are significant political and other risks that come with investing in China, and these China funds posted sizable losses in 1997, 1998, 2000, 2001, and 2002. Moreover, rapid economic growth doesn't always translate into strong market performance: China funds in US lag Pacific/Asia ex-Japan offerings over the trailing three-, five-, and 10-year periods, despite the considerable success of the Chinese economy.

As for other single country emerging markets funds, they are as dangerous as China funds, if not more so. Not only does these emerging markets have high political risk, but funds that focus on these nations are exceptionally concentrated sectorwise (like Russia), or are with flying concerns over high valuations (like India). The perils of these funds are more than theoretical. ING Russia has suffered double-digit losses in 23 rolling three-month periods in the past decade and plunged 69% during its worst such period.

Certain Narrow Regional Funds Are Thriving
A number of narrow regional funds are near the top of the foreign chart this year. T. Rowe Price Latin America has gained more than 40% and ranks 12th among the 800 international-stock offerings for the year to date, while all the other Latin America funds have returned 33% or more in 2006. These funds are only slightly broader than single-country emerging-markets funds, though. Citing Latin America funds as examples, they invest nearly all of their assets in Brazil and Mexico.

Because of their focus on a limited number of emerging markets and the various risks that come with such concentration, these funds are pretty explosive: Latin America funds have been the most volatile category of international-stock funds, and emerging Europe funds, which are part of the Europe category, have been nearly as volatile as Latin America offerings.

Many Focused Small-Cap Funds Are Flourishing
Small-cap funds are well represented on the list of this year's international winners. Indeed, four such funds in US have gained more than 38% and rank among the 25 best international-stock offerings for the year to date through Nov. 30, and one other has performed nearly as well. On another hand, only one foreign large-cap fund, namely, Janus Overseas, is standing at the 10th best international-stock offering for the year to date.

No matter large or small, they all have a common feature: heavily concentrated. These top-performing funds concentrate on firms from a particular region, subregion, or country, which makes them extremely explosive. For instance, Janus Overseas had more than 40% of its assets invested in the developing world as of Sept. 30, showing this explosive nature.

The vast majority of the funds that are at the top of this year's international chart should be avoided by most investors. Indeed, while Janus Overseas might effectively be used as a small complement to a value- and developed-markets-oriented core foreign holding, nearly all of this year's other overseas leaders are so focused and risky that they don't work well as supplements to core foreign holdings. What's more, many of this year's winners also posted big gains in 2004 and 2005, so they're currently carrying quite a bit of price risk as well as all their usual risks, and they could well cool off before too long. Finally, it's worth noting that it is not just this year's international winners' board that is problematic: It's generally not a good idea to pick any type of fund simply because it makes an annual leaders' list.

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About Author

William Samuel Rocco  William Samuel Rocco is a senior fund analyst with Morningstar. He would like to hear from you, but he cannot provide individual-portfolio or financial-planning advice.

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