Just Say Nyet to Russian and Eastern European Funds

This is the first in a series of in-depth looks at this year's outlook for international funds.

If you were asked to guess what the best-performing European fund so far this year was, chances are you wouldn't name the $2 million (TMRFX)Third Millennium Russia fund.

But there it is atop Morningstar's list of the top 10 performing European funds this year with a 31% year-to-date return. Coming in second is the $39 million (LETRX)Pilgrim Troika Dialog Russia fund with a year-to-date return of 26.7% as of Feb. 16.

On top of that, the third and fourth top-performing European funds this year both hail from Eastern Europe -- the tiny $2 million (PTEEX)Pictet Eastern European fund with a 6.4% return year-to-date and the small $4 million (EUROX)Regent Eastern European fund with a return of 4.58% so far this year. Meanwhile, the average European fund is down 5.48% for the year, according to Morningstar.

But while Russian and Eastern European mutual funds might be outperforming the rest of Europe so far this year, that doesn't mean investors should dive into these waters without a life preserver. The Third Millennium fund may be a leader right now, but its return for year 2000 was a dismal -29.4%. The year before, the fund saw a spectacular rise of 145%. Because of these wild swings in performance, fund analysts say most mainstream investors should devote only a small sliver of their total portfolio to these areas.

"Invariably, you'll see these funds at the bottom or the top," says Morningstar senior analyst Kunal Kapoor. "Just because they're at the top right now doesn't mean they won't be at the bottom by the end of the year."

Top 10 Performing European Funds Year to Date*
Fund	Y-T-D Return	One-Year	Three-Year	Five-Year
(TMRFX)Third Millennium Russia	31.1%	-9.14%	N/A	N/A
(LETRX)Pilgrim Troika Dialog Russia A	26.7	-6.40	-18.01	N/A
(PTEEX)Pictet Eastern European	6.42	-16.02	N/A	N/A
(EUROX)Regent Eastern European	4.58	-25.90	-5.84	N/A
(TEMIX)Mutual European A	1.56	7.03	19.41	N/A
(DFCSX)DFA Continental Small Company	1.06	2.00	4.76	8.31
(DFUKX)DFA U.K. Small Company	-0.65	-4.86	5.34	8.92
(ICNEX)ICON North Europe Region	-1.68	-8.28	6.42	N/A
(IEOAX)Ivy European Opportunities A	-1.80	-20.63	N/A	N/A
(FIEUX)Fidelity Europe	-1.91	-13.19	6.30	13.67
*As of Feb. 16, 2001 Source: Morningstar

One important factor to note is that not everyone categorizes funds that specialize in Russia and Eastern Europe as European funds. Morningstar does, but other fund trackers like Lipper rank Russian and Eastern European funds in the emerging markets category. That's important to point out because these regions tend to be much more volatile than Western Europe.

Kapoor says investors should generally steer clear of single country funds in favor of more diversified international funds. But if you feel strongly about a single country play, Kapoor suggests a very small allocation of less than 5% in a fund devoted to that nation.

"Do it with your play money," he says.

If you want to reduce risk and play a broader European theme, there are plenty of funds out there that spread their bets over the Continent and have solid long-term track records, and many European fund managers are busily picking their spots to capitalize on trends in the region. Though those funds are more focused -- and therefore riskier -- than general international funds, some analysts say a small foothold in Europe could add some zip to a diversified portfolio.

"I think Europe, and to a lesser degree Japan, those areas may do well over the next couple of years because they're a little more attractively priced," says Chris Staples, assistant vice president of mutual fund research at financial services firm Raymond James.

As in the U.S., many European mutual funds that focus on large growth companies are underperforming small- and mid-cap value funds so far this year as investors shun pricey tech stocks in favor of Old Economy value fare. Among Europe's top 10 performing funds for the year are value plays like the (TEMIX)Mutual European fund and small company funds like the (DFCSX)DFA Continental Small Company fund.

Analysts say the trend toward value in Europe is not surprising given how closely European markets mirror trends in the U.S. these days. A look at some of Mutual European's major holdings at the end of 2000 shows a host of Old Economy European stocks like French construction company Vinci, French media conglomerate Vivendi Universal (V) and Spanish construction firm Acciona.

"Last year, you found sort of a spillover effect from the Nasdaq correction into the international markets," says Staples. "It's a similar kind of shift that you saw domestically into more value-oriented, more basic industries in favor with investors."

Though that is the case, many growth managers say they are undaunted and continue to look for attractively priced growth names in the region.

The (MEUVX)Deutsche European Equity fund, for example, a large growth fund that is down some 4.5% year to date after a phenomenal rise of 87% in 2000, is focusing on financials and other interest rate-sensitive names -- a move the fund fortuitously started making at the end of February last year before the global selloff in technology.

As of the end of 2000, the fund had 34% in financials, 11.2% in consumer discretionary stocks and almost 11% in health care, and was underweight in sectors like media and telecommunications, although the fund's top stock holding was a 3.3% stake in wireless giant Vodafone Group (VOD).

Co-manager of the fund Clare Brody says she sees some opportunities in Eastern Europe, with small stakes in companies like Croatian pharmaceutical firm Pliva, Polish telecom company Telekomunikacja Polska and Russian oil concern Lukoil. But the fund is mainly rooted in developed countries, with its largest three weightings in the U.K., Italy and France.

"We have a pretty good mix of names in mature industrial countries and more peripheral markets," says Brody.

Though it doesn't dip into Eastern Europe, Merrill Lynch's (MPEAX)Mercury Pan-European Growth fund is looking to capitalize on some of Europe's changing trends. The fund, which is closely benchmarked to the Morgan Stanley Capital International (MSCI) Europe index, will slightly overweight companies the fund managers think will benefit from these trends.

For example, a movement toward a more part-time and temporary labor force should help companies like Swiss employment group Adecco (ADO), in which the fund had a 0.83% stake at the end of January. Similarly, pension reform, which is expected to lead to more investing, is a move that is expected to benefit asset management companies like ING Groep (ING). The fund had a 2.1% holding in that group at the end of January.

"We're not out there taking huge sector bets, but at the margin, we will take that outsourcing bet," says Geir A. Watland, a product specialist at Merrill Lynch Investment Managers, which runs Mercury Pan-European Growth Fund.

Watland also notes that the fund group is bearish on large European telcos like France Telecom (FTE) and Deutsche Telekom (DT), but is upbeat on Vodafone, in which the fund has its largest stake of almost 5%.

"Although [Vodafone] is a megacap, it has been beaten down quite a bit more than is justified," says Watland, who says many of Merrill Lynch's portfolios are overweight the stock.

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