Call it the year of the setting sun.

After a fantastic run-up last year, Japan isn't giving mutual fund investors much to celebrate in the new millennium. With the average Japan fund returning negative 7.8% this year, investors and money managers are shifting their assets to Europe.

Of the 51 Japan funds tracked by

Morningstar

, only two --

(MJFOX) - Get Report

Matthews Japan and

(DFJSX) - Get Report

DFA Japan Small Company -- are in the black this year.

Goin' West
Mutual fund investment is following returns out of Japan and back to Europe.

Source: Financial Research

Diane Finnerty, a money manager with

Ventur Asset Management

in Locust Valley, N.Y., says she dumped her clients' shares of the

(WPJPX)

Warburg Pincus Japan Small Company fund in January, following its spectacular 328% return in 1999. She picked up

(MEUEX)

Deutsche European Equity, a fund that has risen 114% year to date by focusing on the same types of companies, mainly in the wireless sector, that Finnerty had favored in Japan. Among its top holdings are Finnish cell-phone maker

Nokia

(NOK) - Get Report

, up 13.8%, British telecom giant

Vodafone AirTouch

(VOD) - Get Report

, up 18.2%, and Germany's

Mannesmann

(MNNSY)

, up 40.2%.

After struggling through a period of slow growth, European funds are up 9% this year, on average, and are replacing Japan funds as the hot international play. Telecommunications, media and technology stocks have been on a tear and are contributing heavily to the funds' gains. This sector, known lately by the acronym TMT, makes up about 35% of the European stock market capitalization.

An example of TMT highfliers are two Dutch stocks,

VersaTel Telecom

(VRSA)

TheStreet Recommends

, up 55.8% year to date, and pay-TV service provider

MIH

(MIHL)

, which has gained 28.4%.

Investors believe Europe is two years behind the U.S. in the development of Internet technologies, and is thus due for the kinds of returns that drove last year's run-up in the

Nasdaq

. Valuations of these stocks in Europe are significantly lower than in the U.S., though that has changed recently because of a relative paucity of European issues.

"There was a lot of enthusiasm for wireless Internet. Now a lot of these names don't look so cheap anymore," says Thomas Mengel, portfolio manager of

Waddell & Reed's

(WRGIX)

International Growth and

(UNCGX)

United International Growth funds.

Mengel has trimmed his funds' Japan holdings over the past six months and moved those proceeds into Europe. His funds now have 72% allocation to the Continent, up from 60% on Dec. 31. At the same time, his Japan exposure, which had been 22% at year-end, is now 12%. What's worrisome about Japan, he says, is that the decade-long recession isn't over.

In fact, the Japanese market slipped back into recession at the end of 1999. For the country's fiscal year, which ends March 31, gross domestic product is expected to rise an anemic 0.6%. As a result, consumer spending in Japan has all but shut down. Japan's

Topix

broad market index is down 3.7% year to date.

A slowdown in corporate restructurings is partly to blame. But some money managers say last year's gains -- the average Japan fund was up 114% -- were simply unsustainable.

Softbank

, a New Economy holding company and a top pick of many of last year's highflying funds, logged a 1,512% gain in 1999. In 2000, though, it's off by about 1%. Electronics components manufacturer

Kyocera

(KYO)

is down 45.5% this year after rising 410% last year. And

Nippon Telegraph and Telephone

(NTT)

is down 22.2%, following a 133% rise last year.

"All the stuff that ran up so much last year has corrected," says Jim Bogin, portfolio manager of the $25 million Matthews Japan fund in San Francisco. "You have a stock like Softbank. Typically these things don't go up 40 times each year."

Still, investors in Japan say prospects are not hopeless. Hundreds of billions of yen are socked away in ultra-safe Japanese postal accounts, which are similar to U.S. certificates of deposits. About half of those accounts come due next month. And because of Japan's minuscule interest rates, some of that cash could end up back in the stock market, driving up prices.

Based on that projection, Bogin, for example, is taking a big bet on brokerage houses, allotting about 25% of his fund's portfolio to that sector. He's stayed away from telecom recently, which could explain why his fund is up 18.6% in the year to date, on top of a 107% gain in 1999.

"If the Japanese market does fine, then the brokerages will do great," he says.