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This is the third in a series of stories examining the outlook for international funds. Check out our previous articles on European funds and emerging market funds.

While Asia mutual funds have been bouncing back from a difficult 2000, Japan funds are still sitting out the party, and it could be a while before they put on their dancing shoes again, analysts and fund managers say.

After a dismal 2000 that saw Pacific/Asia (except Japan) funds shed 28.5% on average, the category is leading

Morningstar's

ranking of international funds so far this year, with an average year-to-date return of 4.78%. Two funds in the category are up more than 20% already.

Meanwhile, diversified Pacific/Asia funds that include Japan are down an average of 0.88% after a drop of almost 35% for the category last year, while Japan funds are down almost 5% this year, compared with a loss of 35% last year.

Analysts say that Asia ex-Japan and other emerging markets have gotten a lift from the

Federal Reserve's

rate cuts in January, which will presumably jump-start the U.S. economy and boost the exports of emerging economies.

One fund shop reaping the benefits is

Matthews International Funds

, a group of six no-load mutual funds that invest in Asia. Three of them, the

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Matthews Korea, the

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Matthews China and the

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Matthews Pacific are among the top 10 this year in Morningstar's Asia/Pacific ex-Japan category.

Andrew Foster, assistant portfolio manager on the Pacific Tiger and the

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Matthews Asian Technology fund, says the prospects for rate cuts both in the U.S. and Asia, along with potential consolidation activity, make the area attractive right now.

"Now with the Fed easing, there's more than enough room for Asian economies to ease without doing significant damage to their currencies or inflation rates," says Foster.

To take advantage of this, the three leading Matthews funds are heavy in financials, a sector that benefits from the increased lending activity that a lower interest-rate environment inspires. Each fund has roughly a 30% stake in financials -- a sector Foster says the firm started loading up on early last year.

Besides financials, Foster says some technology companies are well positioned to take advantage of demographic and economic trends in Asia. One of those is Chinese computer maker

Legend Holdings

, which Foster says is posting significant growth rates despite a slowdown in personal computer sales in regions like the U.S. A low PC penetration rate in China -- around 2%, Foster estimates -- means the market is in the steeper part of the growth cycle. The Matthews China Fund has 3.7% of its assets in Legend.

Another company Matthews holds in the Pacific Tiger and technology funds is Taiwanese chip designer

Via Technologies

, which Foster applauds for its healthy growth rate despite competition from U.S. rivals such as

Intel

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.

As for Japan funds, the few that are in positive territory, like the

(WPJPX)

Warburg Pincus Japan Small Company fund, which is leading the category with an 8.97% return this year, and the

(WPJAX)

Warburg Pincus Japan Growth fund, which ranks second in the category with a 1.58% return, have gotten a boost from their large stakes in technology and telecommunications.

And although those sectors have benefited from the Fed's interest-rate cuts, the past month has not been so kind, as Japanese markets mirrored the tech selloff in the U.S. The Warburg Pincus Japan Growth fund, for example, shed 10% in the one-month period ended Feb. 26, while the Japan Small Company fund lost almost 7.3% during the same time period.

That dependence on the fates of the U.S. markets, along with an overwhelming sense of disappointment over the Japanese government's failure to reform the country's ailing banking system, could make Japan a difficult place to invest for some time to come, say analysts.

"In terms of the macro situation, it looks pretty grim, and Japan mutual funds have suffered greatly," says Morningstar mutual fund analyst Heather Haynos, who says that last year's 35% drop among Japanese mutual funds was the steepest since the fund tracker started covering the Japanese fund sector in the late 1970's.

Nicholas Edwards, the manager of the Warburg Pincus Japan funds, knows that all too well. After his tech-laden Japan growth and small-company funds rose an astounding 260% and 329%, respectively, amid the frenzy for tech stocks in 1999, an influx from investors chasing performance, together with the market's run-up, swelled the two funds' combined assets to $2 billion by the end of that year from $100 million. But that all changed in 2000 when a disappointing year for the Japanese stock market, along with redemptions and massive capital gains distributions, shrank the funds' asset base by about $1.7 billion.

Now with roughly $150 million in each fund, Edwards says he's continuing to search for companies that are actively making changes to succeed in the New Economy. Edwards agrees that serious reforms need to occur in the Japanese banking system for the country to get back on its feet, but he says that opportunities exist on a company-by-company basis.

"The companies themselves have continued to make progress in terms of restructuring," says Edwards. "On the private, micro-company level, there is every acceptance that the Anglo-Saxon model has to be established. The issue is, can that be sustained?"

Companies Edwards believes are doing things right include mobile phone company

NTT DoCoMo,

which boasted an astounding 57% share of the Japanese market at the end of fiscal 2000. The Warburg Pincus small company fund held a 7.06% stake and the growth fund a 6.21% stake in DoCoMo at the end of last year. Edwards also says he's started taking a look at electronics firm

Sega

, which recently announced plans to restructure.

For individual investors, whether to make a bet on Asia right now is a personal decision, but fund analysts advise that only investors with time lines of 10 years or more should think about investing in an Asian fund, and even then, they should put no more than 5% of their portfolios in the region because of the volatility. Investors might also want to consider buying an international fund with a hefty dose of Asian equities to offset any selloffs in the region.

"People could see it as a good time to buy in if they have long-term convictions about Japanese or broader Asian markets," says Morningstar's Haynos, adding, "These type of funds are so volatile over a three-to-five-year period, that to get any benefit from them one should take a 10-year approach."