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The Year in Review 2007

Emerging Markets Lead the Way in 2007, UK Equities, Property Slump

Christopher J. Traulsen, CFA 27 December, 2007 | 11:47AM
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With UK equities slumping and the property market taking a dive in the year's second half, 2007 is a year that many investors would like to forget. Amid it all, three key factors defined fund performance. A global credit crisis with its roots in US subprime lending wreaked havoc around the world; emerging markets continued to soar; and commodities--driven in large part by strong demand from China--climbed sharply.

The first whiff of the seriousness of the credit crisis came when HSBC's U.S. subprime unit warned over high delinquencies in early 2007. This was followed by New Century Financial --a major U.S. subprime lender--filing for bankruptcy in April. By August and September, it became clear that subprime risk was widely dispersed around the globe. Three money funds run by BNP Parib

as had to suspend dealing, some of the largest banks in Europe, including Barclays and Deutsche Bank, suffered losses due to their exposures. In response, lenders tightened their purse strings and liquidity in global credit markets all but evaporated.

In the UK, the credit crunch led to the near-collapse of lender Northern Rock, which depended on ready access to credit to fund its operations. News of Northern Rock's difficulties led to a run on the bank and an embarrassing about face by Mervyn King as the Bank of England were forced to bail out the Rock almost immediately after saying they viewed such bail outs as moral hazards.

UK Equity Funds Slump
The credit crunch wreaked havoc on equity markets around the world, and the UK was no exception. From 1 June through 30 November, the FTSE 100 index fell 1.3 per cent, and the FTSE 250 dropped 10.3 per cent.* The trend was clearly reflected in fund performance: In the same period, the Morningstar UK Small-Cap Equity fund category average fell 13.7 per cent; the Morningstar UK Mid-Cap Equity category dropped 8.1 per cent, and the average UK Large-Cap Blend Equity offering fell 5.2 per cent. Notable in this trend is a sharp reversal form precious years dating back to before 2000: Whereas small- and mid-caps have led the way since at least the turn of the century, large-caps held up better during the downturn. This reflected in part the perceived stability in large-caps and the greater dependence of small- and mid-caps on ready credit, but it also likely stemmed from investor nervousness over the valuations of small- and mid-cap issues, which had reached high levels by historical standards.

For the year to date through December 26, UK equity returns followed a similar pattern (see table, below). The one exception was that UK Large-Cap Value funds (which includes most income-oriented offerings) lost a bit more, on average, than UK Mid-Cap Equity funds. This owes in large part to their greater dependence on the hard-hit financials sector.

A Poor Year: Performance of Morningstar UK Equity Categories in 2007
Morningstar Category 1m 3m 6m YTD 3Yr 5Yr
UK Large-Cap Blend Equity 3.80 -1.78 -3.74 2.53 13.23 13.92
UK Large-Cap Growth Equity 4.63 -2.56 -5.72 0.02 11.81 12.98
UK Mid-Cap Equity 2.40 -3.70 -7.05 -1.64 13.00 16.66
UK Large-Cap Value Equity 2.96 -3.27 -6.20 -2.00 11.90 13.85
UK Small-Cap Equity -1.09 -9.68 -14.35 -7.74 12.23 18.98
Total Returns as of 26-12-07. Returns for periods longer than one year are annualised.

Property Cracks
 Amid the credit crunch, the heretofore levitating UK property markets started to fall back to earth. It had been clear for some time that valuations were stretched, with yields on commercial property at or near all time lows. The credit crisis exacerbated the situation and the rate of growth began to slow, then started to fall. Investors responded by yanking money out of property funds and listed property securities. To forestall the need to sell properties to meet redemptions, "bricks and mortar" property funds changed their pricing to a cancellation basis, erasing large chunks of their value overnight. Some also imposed redemption delays ranging from 90 days to six months, whilst others--most notably New Star--have seen their properties re-valued at lower levels. As a result, some of the biggest property funds in the UK are down north of 15% thus far in 2007, and there seems to be little reason to think they will bounce back any time soon. Click here to read an excellent summary of the situation as it affects UK Commercial Property funds by my colleague Tom Whitelaw.

US Shows Resilience
 Despite the credit-market woes, US equities, led by the high-tech industry, performed relatively well in 2007. Even with the pound strengthening against the dollar, the average Morningstar US Equity Large-Cap Growth fund rose 12.4% in Sterling terms for the year to date through 26 December. As with the UK, however, Large-Cap Value funds fared much worse, rising just 0.2%. This owed largely to their high financials exposure and dearth of technology investments.

Somewhat Better: Performance of Morningstar US Equity Categories in 2007
Morningstar Category 1m 3m 6m YTD 3Yr 5Yr
US Large-Cap Growth Equity 8.83 2.79 5.53 12.37 7.97 7.22
US Mid-Cap Equity 8.64 0.70 1.21 10.01 8.68 9.62
US Large-Cap Blend Equity 8.04 -0.69 -0.85 4.39 6.62 6.23
US Small-Cap Equity 8.97 -1.25 -3.24 3.73 7.78 10.88
US Large-Cap Value Equity 7.70 -2.77 -4.55 0.21 6.07 6.31
Total Returns as of 26-12-07. Returns for periods longer than one year are annualised.

Emerging Markets Soar
 Whilst UK equity offerings slumped, emerging markets continued their tremendous surge, driven in large part by growth in China and the accompanying resources boom. The Morningstar China Equity fund category average jumped 60.8 per cent for the year to date through 26 December, followed by India Equity (+57.7 per cent), Hong Kong Equity (+43.1 per cent), Greater China Equity (+40.7 per cent), and Latin America Equity (+39.3 per cent). The Morningstar Emerging Markets Equity category, which contains global emerging markets offerings, finished up 34.3 per cent for the period. Emerging Europe Equity funds were close behind, with a 29.3 per cent gain.

Best: Performance of Morningstar Emerging Markets Equity Categories in 2007
Morningstar Category 1m 3m 6m YTD 3Yr 5Yr
China Equity 7.38 2.14 28.93 60.78 46.67 36.02
India Equity 10.03 21.79 40.07 57.66 44.33 44.34
Hong Kong Equity 9.05 6.88 25.59 43.10 30.02 27.20
Greater China Equity 6.36 1.32 19.71 40.68 31.99 25.87
Latin America Equity 6.63 7.92 12.09 39.33 43.66 39.80
Emerging Markets Equity 6.98 8.10 16.88 34.27 32.46 28.22
Emerging Europe Equity 8.37 10.03 18.41 29.30 38.02 36.31
Russia Equity 9.70 16.29 22.88 26.05 51.06 41.28
Total Returns as of 26-12-07. Returns for periods longer than one year are annualised.

Economic Sector Wrap: Resources Shine; Property, Financials Slide
 China's rapid growth has caused a large increase in demand for basic resources such as metals and energy. This was reflected in the performance of funds focused on economic sectors in 2007. The Morningstar Sector Equity Energy category rose 28 per cent for the year to date through 26 December, whilst the Sector Equity Industrial Materials category climbed 26.2 per cent. Funds in the Sector Equity Precious Metals category gained an average of 16.2 per cent. Property was among the worst performers for the period, with the Morningstar Sector Equity: Real Estate Indirect - Europe category down 21.3 per cent (the category contains funds that invest in listed property securities in Europe including the UK). Funds focused on financials were particularly hard hit by the credit crunch, and the Morningstar Sector Equity Financial Services category lost 5.3 per cent, on average, for the year to date through 26 December.

Sector Wrap: Performance of Morningstar Sector Equity Categories in 2007
Morningstar Category 1m 3m 6m YTD 3Yr 5Yr
Sector Equity Energy 7.58 5.92 10.49 27.99 26.04 22.12
Sector Equity Industrial Materials 5.58 3.63 8.55 26.21 25.69 22.65
Sector Equity Utilities 5.17 9.85 13.04 22.42 23.96 21.92
Sector Equity Communications 4.21 3.78 8.54 16.38 11.93 12.21
Sector Equity Precious Metals 0.13 1.36 13.47 16.19 22.88 17.45
Sector Equity Real Estate Indirect Asia 2.19 -1.51 -1.51 12.09 26.75 22.05
Sector Equity Technology 6.13 0.03 2.63 10.58 9.22 10.19
Sector Equity Consumer Goods & Services 4.80 0.50 1.21 7.66 11.13 10.61
Sector Equity Health Care 5.46 1.38 2.53 4.41 6.58 6.06
Sector Equity Biotechnology 4.96 -0.37 2.14 3.19 4.90 7.33
Sector Equity Real Estate Direct -1.11 -1.97 0.88 0.76 5.36 6.63
Sector Equity Financial Services 6.09 -3.62 -8.80 -5.30 10.87 12.07
Sector Equity Real Estate Indirect 1.90 -8.01 -10.28 -12.69 8.65 15.91
Sector Equity Real Estate Indirect Europe 0.57 -11.21 -17.64 -21.26 12.40 20.15
Total Returns as of 26-12-07. Returns for periods longer than one year are annualised.

*All returns in this article are stated in Sterling. All category averages include offerings available for sale in Europe and select Asian countries.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Christopher J. Traulsen, CFA  is director of fund research, Europe and Asia, Morningstar.

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