The best ways to invest in Europe

By Morningstar

It's not news that emerging markets have been hot in recent years, fueled by explosive growth rates and high commodity prices. The boom has even given us "BRIC" (referring to Brazil, Russia, India and China), the most overused investment abbreviation since "TMT" (technology, media and telecommunications).

Less covered has been the incredible rise of Europe, a region many were essentially writing off just a few years ago. The MSCI Europe Index has climbed 25% per year, on average, for the trailing three-year period. That's not too far behind the gains posted by emerging markets. Mutual funds in the European-stock category have been on fire, outdistancing all but a handful of other fund groups.

We've been getting an increasing number of calls about investing in Europe lately. For that reason, we thought this would be the perfect time to take a closer look at the region, the reasons behind its rally and the best ways to get exposure to Europe.

Europe's bull run

For U.S. investors, the dollar's decline versus European currencies has dramatically boosted European equity returns. If you own a mutual fund that takes your U.S. dollars and uses them to buy stocks denominated in euros, pounds, Swiss francs or Swedish kronor (or even U.S.-listed versions of those stocks), the fund's portfolio gains in value when those currencies appreciate, so long as the fund is not hedging its currency exposure.

Roughly 5 percentage points of the MSCI Europe's gain over the past three years comes from currency, and it has played an even bigger role over the trailing five-year period.

But the story doesn't end with currency gains. There are more-fundamental drivers of European stock gains. First, many of Europe's largest companies are global players, and their success reflects global factors, such as high oil prices. These days, where a company is headquartered can be incidental. Then there are factors specific to Europe, such as low interest rates, that have spurred economic growth and business activity.

Low rates have also helped foment cross-border mergers and acquisitions, such as Italian bank UniCredito Italiano Group's (IT:UC, news, msgs) purchase of German HVB (DE:HVA1, news, msgs), French spirits company Pernod Ricard's (FR:RI, news, msgs) purchase of Britain's Allied Domecq and the frenzied jockeying for Spanish utility Endesa (ELE, news, msgs) and Dutch bank ABN Amro (ABN, news, msgs). Competitiveness has improved, too, in many cases. Just like their U.S. counterparts, lots of European companies have restructured, automated, outsourced and offshored their way to higher profits.

Eastern Europe is another factor. The European Union has expanded in the past few years to include several former communist countries, notably Poland, Hungary, the Czech Republic, Romania and Bulgaria. West European companies have in many cases moved manufacturing and back-office operations to these lower-cost countries. West European companies such as banks and retailers have benefited from Eastern Europe's growth.

Eastern Europe has had an even more direct impact on the European-stock category's stellar returns. There are several funds in the category that focus solely on those emerging markets, the largest being U.S. Global Accolade Eastern Europe (EUROX).

That fund and others like it have posted some of the biggest five-year numbers in Morningstar's entire fund database. Not only do those funds invest in the new European Union entrants, but also in Russia, which has boomed thanks to high commodity prices. A handful of dedicated small-cap funds have also been turbocharged, as European small caps have soared like their U.S. counterparts.

Will Europe continue to shine?

The short answer is "who knows?" Hot markets and hot fund categories often cool off. It's instructive to remember that in the late 1990s, the U.S. market was soaring, the dollar was strong, and some were writing off Europe -- and the euro -- as failures. European stocks still look cheaper than their U.S. counterparts by most metrics, but they have advanced.

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