As 1992 approaches, you'll be reading more and more about the long-awaited removal of economic barriers within the European Community. That move, due to be completed by the end of next year, will create the world's largest single market for goods and services.
You may wonder whether you could share in the profits that European corporations may earn from Western Europe's unification and from the development of the economies of Eastern Europe. One possibility: buying into a mutual fund concentrated in European stocks.
Such funds generally are invested in all or most of the 13 major European stock markets. They're more diversified -- and, therefore, less risky -- than closed-end funds confined to the stocks of only one country. (They are, of course, not as diversified as international funds, which are invested in foreign countries around the world, or global funds, which also own U.S. securities.)
Getting into one of them may not be a bad idea -- provided you stay in it for several years, your portfolio already includes at least one good U.S. equity fund, and you could tolerate the risks (notably the currency risk) inherent in non-dollar securities.
European markets -- and the funds invested in them -- have lagged U.S. stocks on the average recently. But who is to say they may not rise faster than ours for a while?
If you consider a European fund, remember at least two points when you begin your research:
* Because of fluctuations in exchange rates between the U.S. dollar and European currencies, changes of European stock prices in local currencies can differ significantly from changes in their prices after they're translated into dollars. They can even move in opposite directions.
* Stock prices (in local currencies) rise and fall at different times and rates among the 13 major European markets. That's largely because of the differences in the countries' economies.
To appreciate the significance of these points, note in the table that Morgan Stanley Capital International's Europe 13 Index had an average annual total return in local currencies of 8.1 percent for the five-year period that ended last Sept. 30. When translated into dollars, however, the return rate became 12.1 percent because the dollar weakened during the period.
On the other hand, you'll find the index had a total return of 27.0 percent in local currencies for the year that ended Sept. 30 -- but one of only 18.5 percent in dollars because the dollar strengthened during these 12 months.
Naturally, it's the dollar-based returns that matter more to you. They can be compared with alternative investments, such as the U.S. stock market, as measured by the Standard & Poor's 500 index.
Although the Europe 13 dollar index lagged the S&P 500 in the last five- and three-year periods, some European countries had higher returns. In the five years, for example, Denmark and the United Kingdom had average annual returns of 24.0 percent and 19.8 percent, respectively -- well ahead of the S&P's 14.7 percent. On the other hand, Swiss and German stocks posted dollar returns of only 6 percent, and Italian stocks lost money in both lira and dollar terms.
For the latest year, no European market exceeded the S&P, but the United Kingdom and Spain came close to matching it.
Because of these considerations, the performance of European funds has depended heavily on the choice of countries and response to currency risk -- as well as on the selection of industries and firms.
The U.K., whose stocks account for about 38 percent of the value of all stocks reflected in the Morgan Stanley index, was the place to be. Funds with a high percentage of assets there, such as Merrill Lynch EuroFund, Financial Funds' European Portfolio and Vanguard's European Portfolio (which managed to match the index) have done relatively well.
Some portfolio managers, such as Merrill Lynch's Alan Albert, engaged in currency hedging strategies to reduce the risk that the appreciation of their stocks could be offset by the fall of European currencies vs. the dollar. In fact, Albert attributes his fund's strong recent performance in part to successful hedging.
How do managers see the prospects for European stocks?
pTC A common view is that they will become more attractive as Europe follows the United States into recession and into a period of interest rate reduction. Many analysts expect widespread cuts once Germany's central bank reduces rates -- but many think the Germans are likely to raise rates one more time to squelch inflationary pressures.
Compared to the high price-earnings ratios at which U.S. stocks sell, European stocks are cheap, Financial Funds' Steven Chamberlain says. G.T. Capital's chief investment officer, Christian Wignall, wonders, however, whether earnings estimates may have to be cut -- especially in Germany -- a move that would boost ratios. Albert, on the other hand, points out that expected changes in accounting treatment will show that European companies' earnings have been understated.