Satisfactory year for Asia equity funds, but not the smoothest of rides

The year to end October 2006 proved challenging for Asia managers, who were confronted with stalling performance in Japanese equities combined with a severe sell-off in May and June. Standard & Poor’s latest annual review of the sector, available at funds-sp.com, highlights managers’ strategy and responses to a period when most of the gains generated from the beginning of the year ended the review period below May's peak.

This year, we have included 51 funds in this review, broken down into 11 in the Pacific sector and 40 in the SEA sector. The inclusion of Japan is the main difference between the former and the latter. Of these 51 funds, three achieved an AAA rating, while 17 were AA rated and 25 A rated. In addition, two were covered but Not Rated because, following a change in manager, the new management team did not have a demonstrable track record. In addition, one fund was placed under review. A further three will be rated shortly.

“Although most fund managers interviewed during this review are above all stockpickers, success was partly dependent on identifying and following a number of themes”, Thomas Lancereau, Standard and Poor’s fund analyst states. “Investors’ focus is increasingly being placed on growth in domestic consumption in most countries, including Japan”. However, this is played out through a variety of means. Vincent Strauss at Comgest, for instance, tends to favour telecom stocks in China and Indonesia. Mark Mobius favoured banks in Thailand to benefit from domestic growth. Banks were also a preferred investment vehicle for Thomas Gerhardt at DWS in order to benefit from the increase in mortgage lending in India.

For Pacific funds as a whole, being underweight Japan was key to a successful strategy. In the S& P Pacific sector, the exposure to Japan varies considerably from one fund to another. This ranges for instance from as high as 67% in the case of the AA-rated Raiffeisen Pazifik Aktien Fund to only 22% for the A-rated DWS Invest Top 50 Asia. In terms of asset allocation, fund managers were overall not concerned on the outlook of Japanese equities. They remained, however, all underweight their respective benchmarks as they continued to find more attractive opportunities elsewhere in the region.

“One key place of choice in 2006 has been China”, Lancereau points out, “where the combination of renewed investor optimism and buoyant IPO activity have triggered an impressive rally. Most fund managers were extremely enthusiastic about the country's prospects and welcomed the wave of IPOs, in particular Chinese banks.” Although most managers recognised they were allocated only small portions of those, they stress that they contribute to provide more depth and breadth to the Chinese equity market. However, Rajiv Jain, who manages the AA-rated Vontobel Far East Equity Fund, was the exception. His emphasis on quality and sustainability has led him to avoid China, where he remains sceptical about the predictability of reported earnings trend and corporate governance.

The outperformance of the Indian equities market benefited both the AAA rated CG Nouvelle Asie and A-rated DWS Top 50 Asien, two of the funds with the highest exposure to this market, at around 17% of assets. Mark Mobius, who manages the AA-rated Franklin Templeton Asian Growth Fund, tends to remain away from India as he considers valuations are unattractive. He continues to favour Thailand and even added on the correction following the military coup.

Since the beginning of the year to October 2006, Korea and Taiwan have been the laggards. The former, which is heavily biased towards technology stocks, suffered from the underperformance of this market globally. On another hand, its banks, another major constituent of its stock market, remained out of favour following the credit crisis. In Korea, one of the best performing markets in 2005, underperformance has been exacerbated by the increased tensions with its northern neighbour.

Most fund managers have reduced their exposure to the commodities sector over the review period, following their price correction. Mark Mobius remained however fairly sanguine on the energy sector, maintaining around 30% of the Franklin Templeton Asian Growth Fund in oil-related stocks, considering most companies still highly profitable at current oil prices. After trimming his exposure before the correction, Bill Sung, who manages the A-rated IXIS AMA Pacific Rim equities fund was also selectively adding into oil and mining stocks, mostly in Australia.

The fund managers have a positive outlook on the prospects for Asian stocks markets. They consider valuations are fair (with the exception of India for some of them) and amply justified by the growth differential with the rest of the world. The main risk to this rosy scenario lies, for most of them, in an underestimation of inflation and its eventual impact on interest rates worldwide, primarily in the USA.