JonathanBurton

SAN FRANCISCO (MarketWatch) — Investors in international stock mutual funds and ETFs have been in a world of hurt. But now the managers of those funds are spinning the globe and finding bargains among the bramble.

Mutual fund returns tell a tale of the taper

The Federal Reserves moves were key to U.S. stock and bond fund returns in the first half of 2013, and thats likely to continue. MarketWatchs Jonathan Burton reports. (Photo: Getty Images)

“Contrarians, start your engines,” trumpeted the headline of a recent Bank of America Merrill Lynch report on global fund manager sentiment. Investors’ exodus from emerging-market stocks, which accelerated in the second quarter, has created a buying opportunity in those areas, BofA strategists asserted.

Meanwhile, managers’ outlook for the beleaguered euro zone has improved noticeably. The number of managers expecting Europe’s economy to improve and corporate profits to climb is at its highest level since February 2011, a BofA survey showed. In addition, managers are much less defensive in their sector allocation and are buying what they perceive as cheap.

“Because the recent damage has been greater in Europe and emerging markets, valuations are starting to looking better,” says David Lafferty, a Boston-based investment strategist at Natixis Global Asset Management.

“Europe is through the worst,” adds Stephen Auth, chief investment officer at mutual-fund giant Federated Investors. “It’s heading to a better place.”

Indeed, Europe stock funds with their 0.8% average gain were a relative bright spot on the map in the second quarter.

Japan funds fared best of any category outside of the U.S.. up 4.3% in the quarter and 19.3% in the first half. One standout: WisdomTree Japan Hedged Equity Fund. This popular exchange-traded fund DXJ, +2.02%  soared 6.2% in the quarter and was up 24.2% for the year through June, according to preliminary results from investment researcher Morningstar Inc. as investors embraced Japan’s efforts to devalue the yen USDJPY, +0.07%  and slay the deflation that has plagued Japan’s economy and limited Japanese consumer spending.

“The Japanese get this,” Auth says about the concerted change in fiscal and monetary policy. “It’s changing their psychology. Japanese households have money; they’ll start spending.”

Fund performance in other markets wasn’t so encouraging. Every other Morningstar foreign-stock fund category lost ground in the quarter. Diversified international stock funds shed 2.1% on average. Latin America stock funds were hit hardest, down 15.6%, while diversified emerging markets funds lost 7.5% and Asia-stock funds that eschew Japan fell 5.9%.

But the sharp decline in emerging market stocks, coming after a multiyear downturn, was evidently enough to lure bargain-minded value investors.

“We’ve seen this selloff, but I think it’s going to be short-lived,” says Sarah Ketterer, manager of Causeway International Value Fund CIVVX, +1.01% which added 2.6% in the quarter.

Moreover, she says, “valuation clearly favors emerging over developed.” The performance gap between emerging and developed markets is the widest its been since 1998, Ketterer notes. “The discounts are not warranted,” she says. “Ultimately the valuation gap will close.”

All bets are off, however, should China’s leadership fail to respond effectively to the country’s slowing economic growth. China-region funds slid 4.2% in the quarter, reflecting such concern.

“The wild card is China,” says Natixis’s Lafferty. “The bet that’s really implicit in the market today is that the Chinese can manage their growth lower in an orderly fashion,” avoiding what’s known as an economic “hard landing” that could send shock waves across world markets.

“The Chinese market has an impact everywhere,” Ketterer says. But she expresses optimism that China’s new leadership can purge wasteful government spending and clean up the banks. She is especially bullish on the global energy sector, and in China the fund has a stake in oil major CNOOC Ltd. CEO, -0.73% 0883, -0.39%

“Nothing about it looks dire,” she says of China’s economy. “It looks like an adjustment; we see that all the time. Usually in the wake of these adjustments you see a healthier system.”