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Europe's turmoil offers lessons on risk


Now that September's turbulence in European financial markets is behind us, it may be worthwhile to think about whether these developments offer pointers for improving your investment results.

The decline in the pound, the lira and other currencies underscored the importance of being mindful of currency risk -- the risk that another country's currency will fall vs. the U.S. dollar, reducing the dollar value of your stake in that country.

The declines also underscored the importance of diversifying to modulate the impact of changes in relationships among currencies. That's a major reason for investing in mutual funds instead of in individual securities when you want to participate in foreign markets.

Perhaps no fund investors were more surprised by the month's demonstration of currency risk than those who had bought some short-term world multi-market income funds -- funds that took a beating.

As the table shows, Lipper Analytical Services calculated that all funds in the group were off by 3.1 percent, on average, for the three weeks ended Sept. 24. That was 1 percentage point more than the average drop of general world income funds, which you would have expected to be more volatile because of their longer maturities.

Shares of the group's second-largest fund, $5.8 billion Merrill Lynch Short-Term Global Income Fund, were off even more -- 4.6 percent. Those of the largest fund, $6.1 billion Alliance Short-Term Multi-Market Trust, fell 3.1 percent, in line with the average. (Neither figure is adjusted for sales loads.)

Why the surprises?

For one thing, the funds were often promoted as ways to earn the higher yields available abroad -- higher than those offered by certificates of deposit or money market funds -- while exposing investors to little volatility. The currency risk associated with them may not have been emphasized -- or understood.

Expectations of low volatility and generous yields were commonly based on the short maturities of the funds' bond portfolios, on funds' conventional strategies to hedge against the risk of the dollar's becoming stronger and on complicated cross-hedging strategies. (For both types of hedges, of course, transaction costs are incurred.)

Pioneered by Alliance's Robert M. Sinche, cross-hedges involve taking positions in high-yield foreign securities while committing to sell lower-yield securities of hard-currency countries.

While the funds usually invested in both European and non-European currencies, the strategies were largely based on the assumption that the stable relationships among major currencies in the European Monetary System would continue.

These assumptions were exploded when Britain suspended membership in the system and raised interest rates as the pound fell.

Noting that his large fund was hurt by rate boosts in countries trying to defend their currencies as well as by long positions in devalued currencies, Mr. Sinche intends to stay with cross-hedging.

"The system's foundation is sounder now," he explained. "While German growth has slowed down, there are fewer imbalances between economies in Europe than there have been in some time."

Martin G. Wade, president and chief investment officer of Rowe Price-Fleming International, which manages T. Rowe Price's international and global bond and equity funds, takes a different position. His firm has suspended use of cross-hedges until he is more confident that the European currency relationships have stabilized.

Agreeing that short-term multi-market funds can be attractive, Mr. Wade holds that U.S. investors also should consider long-term funds that are "designed to be exposed to international currencies."

These funds, in general, have come through the crisis reasonably well, largely because of their non-European holdings. They should benefit when the Bundesbank agrees to cut German interest rates further and other European countries follow. Mr. Wade expects this to occur in the first quarter next year.

That would be good news for Jeffrey Tyler, portfolio manager of the Benham European Government Bond Fund. It was launched this year to invest primarily in European securities, of which at least 25 percent must be denominated in German marks. Mr. Tyler, who expects additional cuts in German rates in the next three to six months, was 40 percent in marks (and about 25 percent in mark-linked currencies) when the German central bank began to ease last month.

For managers of international equity funds, as well as European funds and global funds (which also invest in the United States), interest rate cuts should also be welcome.

These funds were hit last month to about the same degree as bond funds -- making their recent poor performance records worse. But they should fare better when European stock markets really begin to reflect the promise of economic recovery that low rates hold. Says Mr. Wade: "The case for Europe is sound."

Crisis' effects

Effect of Europe's currency crisis on overseas mutual funds. (Figures for periods ended Sept. 24.)

.. .. .. .. .. .. ..Average.. .. .. .. .. ..Average

.. .. .. .. .. .. ..return.. .. .. .. .. .. return

Fund type.. .. .. .3 weeks.. .. .. .. .. .. .1 year



World Multi-

Market Income .. .. .3.1%.. .. .. .. .. .. .. +2.2%

General World

Income.. .. .. .. .. 2.1%.. .. .. .. .. .. ..+10.3%


International.. .. ..2.4%.. .. .. .. .. .. .. .1.5%

Global.. .. .. .. .. 1.9%.. .. .. .. .. .. ...+1.4%

European Region.. .. 4.9%.. .. .. .. .. .. .. .3.9%

Japanese.. .. .. .. +1.0%.. .. .. .. .. .. .. 22.3%

SOURCE: Lipper Analytical Services

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