Asia Offers Chance to Hedge Bets

One of the best arguments for owning foreign as well as domestic stocks and mutual funds is that geographical diversification dampens risk and provides more dependable returns.

When overseas markets mirror our own, those benefits are blunted. And part of the reason that the Japanese stock market in particular and Asian markets in general are in favor at the moment is that their economies are diverging from North America’s.

Another reason, of course, is performance.

Asian stock markets in the first quarter continued to outperform the rest of the world, as the United States and Europe cooled off after a strong 2003.

Among the markets of the top industrialized nations, Japan’s led the way in the first quarter with a 14% advance, in dollar terms, and remains a top pick for many international stock strategists.

South Korean and Taiwanese markets, though smaller and less liquid, also posted double-digit returns for the quarter, while China hit a speed bump after a scorching 2003.

The tricky question -- always the same question, it seems, when Japan is concerned -- is whether the surge is a mirage or the real thing.

Three times in the 1990s, Japanese stocks staged powerful, sustained rallies, lifting Tokyo’s Topix index by 41% (1992-93), 45% (1995-96) and 67% (1998-99). But each time, the advance ultimately fizzled, and Japan sank back into the bear market that has lingered since 1989.

Today, Japan is in the midst of a fourth such rally, one that has driven the Topix index up 57% since March 11, 2003.

Why should this time be any different?

If you’re bullish on Japan, like Michael Hartnett, a global strategist for Merrill Lynch, you have several answers:

First, thanks to a long period of extremely low interest rates and some political will, Japan’s banks have finally made headway in restructuring, knocking down some of the debt that has hobbled them for years and made foreign investors suspicious of the whole financial-services sector.

Second, with the Japanese economy posting its best three years of growth since the 1980s boom, stocks there are being helped by far stronger domestic demand than in the 1990s rallies. Consumers are spending and businesses are investing.

Third, valuations of Japanese stocks, though typically high by global standards, are lower than in the previous advances, Hartnett said in a telephone interview this week.

Investors encouraged by the strong returns of overseas funds last year should bear in mind that the dollar’s weakness exaggerated the returns from many foreign markets.

The German DAX index is up 62% in dollar terms over the last year, but up 42% in euro terms. Similarly, the 68% gain in dollar terms for Tokyo’s Nikkei index shrinks to 48% when measured in yen.

The weak-dollar wind at investors’ backs probably won’t be as strong this year, particularly in Europe, where slowing economic growth may pressure the European Central Bank to cut interest rates, which would weaken the euro. By contrast, most observers expect the U.S. Federal Reserve Board’s next move to be a rate hike, even if it doesn’t come until next year.

The euro hit lows for the year against the dollar Monday, although it rallied Tuesday when an incoming member of the European Central Bank’s policy board said rates already were low enough to spur economic growth.

On the subject of diversification, investors often ask why they should bother with foreign stocks when they can buy U.S. multinationals that operate pretty much everywhere on Earth.

“Microsoft has huge overseas revenue, but its stock is still highly correlated to the U.S. market,” noted Charles F. Lovejoy of Batterymarch Financial Management Inc. in Boston, lead portfolio manager of the Legg Mason International Equity Trust fund.

To properly diversify, investors need exposure to foreign-based firms, not just ones that do business there, Lovejoy said.

From the standpoint of geographic rather than industrial sectors, he said, diversification is aided when a region’s economy runs on a different cycle than that of the United States.

Japan’s economy and markets, for example, are becoming less correlated with those of the U.S. as economic growth blossoms in the rest of Asia. Other Asian countries’ share of Japanese trade has rocketed in the last 10 years to 47% from 25%, Lovejoy said, citing figures from Global Insight Inc.

Europe’s markets, on the other hand, more closely mirror that of the United States, so investors may not be getting the diversification benefits they seek by adding only European holdings to their American ones.

Stock markets on the Continent slowed down nearly in lock step with American equities during the first quarter after posting similarly strong returns in 2003.

If Fed watchers are right and the U.S. central bank begins tightening credit late this year or in 2005, it could be bad news for Latin America, which tends to be especially vulnerable to Fed rate hikes, Hartnett said. Brazil, in particular, has a volatile stock market that is prone to even sharper swings when the Fed is raising rates, he said.

Although others may pound the table for Japan or Korea, Bill Rocco, a Morningstar Inc. senior analyst based in Ashland, Ore., has pounded the table for investing discipline.

Rocco said he shakes his head when he reads “e-mails from people who are clearly retired asking about putting 15% of their retirement funds in China.”

Emerging markets like China’s should be approached with extra-long time horizons -- 10 or 15 years -- and with the idea that investors shouldn’t risk more than they can afford to lose, Rocco said in a telephone interview this week.

Rather than ogling China’s 65% returns for 2003, he said, investors should be asking, “What if my $10,000 becomes $7,000 or $3,000? Can I recover?”

Rocco also emphasized the advantages of dollar-cost averaging -- investing a consistent amount of money on a regular schedule so that you end up buying fewer shares of a fund when the price is high and more shares when it’s cheap.

The practice takes emotion out of the game and keeps investors from buying heavily into a boom just as it’s peaking or backing away entirely from a down market just when it’s ripe for a turnaround.

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Looking beyond Wall Street

As U.S. blue-chip stocks and technology issues slowed sharply in the first quarter after last year’s gains, the hottest stock mutual fund sectors were those that focused on foreign issues, particularly in Asia, and funds that targeted real estate and natural-resource investments.

Five biggest winners

First-quarter return for each fund category

Japan +14.1% Real estate +11.9 Diversified Pacific/Asia +10.6 Foreign small/mid-cap value +9.1 Diversified emerging markets +8.7 Average U.S. stock fund +3.0

Five weakest sectors*

Conservative allocation +2.1 Large-cap blend +1.8 Large-cap growth +1.4 Technology +1.0 Precious metals -1.3

*Excluding bear-market-strategy funds Source: Morningstar Inc.

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Foreign stock performance: a sampling

Some foreign countries may offer attractive investment opportunities. Here is a look at performance, measured in dollar terms, for stock market indexes tracked by Morgan Stanley Capital International for selected countries compared with the Standard & Poor’s 500 index. Percentage change: Country First 1-year 3-year qrtr. Russia +29.4% +125.5% +52.4% Mexico +19.7 +65.9 +14.1 South Korea +16.7 +91.2 +34.1 Japan +14.6 +68.3 +1.8 Argentina +10.8 +84.8 -7.6 Taiwan +10.2 +58.7 +2.0 South Africa +8.0 +66.1 +17.9 Hong Kong +6.0 +50.1 -0.7 Singapore +5.7 +52.1 +4.4 Indonesia +5.6 +95.3 +35.6 Australia +5.2 +48.1 +18.3 Canada +2.4 +49.3 +9.5 France -0.4 +55.1 -0.3 India -1.5 +90.5 +18.4 Brazil -1.9 +91.9 +5.4 China -3.4 +77.7 +7.6 Philippines -3.6 +34.0 -8.8 Germany -4.7 +75.3 -3.3 S&P; 500 +1.7 +35.1 1.9

SOURCE: Morgan Stanley Capital International