Fourth Quarter 2011

During the quarter, the Eastern European Fund performed in line with the benchmark, the MSCI Emerging Europe 10/40 Index.  The Russian MICEX index rose in U.S. dollar terms, while equities in other Eastern European countries declined, with local currencies coming under increasing pressure reflecting euro weakness.

Defensive sectors outperformed, such as consumer staples, telecommunications and health care, while financials, materials and industrials underperformed in the region.

Strengths

• Our stock selection within the materials sector, with significant exposure to gold stocks, had a positive impact on the performance of the fund relative to its index.
• The fund’s underweight position in financials also contributed positively to the relative performance of the fund, as financials were one of the worst-performing sectors.
• Czech risky assets had been performing as safe havens until very recently. We thought that this was unwarranted, given the Czech Republic’s deep economic and financial linkage with Europe, and the fund had no exposure to Czech equities going into November.  Our positioning was rewarded, as third quarter GDP showed contraction and Czech equities declined more than 10 percent in U.S. dollar terms during November.

Weaknesses

• The fund’s underweight position in the telecommunications sector was a detractor from performance, as Russian telecommunications companies, in particular, delivered some of the best returns during the quarter.
• Business conditions continued to deteriorate in November, with Germany’s Purchasing Manager’s Index (PMI) dropping for the seventh consecutive month to 47.9, from 49.1 in October. Czech and Polish economies are linked to Germany’s, and PMIs in both countries followed suit, slipping into contraction territory for the first time since 2009.
• Hungary lost the investment-grade rating it held for 15 years after Moody’s Investors Service cut the country’s credit grade to Ba1 from Baa3, citing risks to budget deficit and public debt targets.

Opportunities

• Turkey’s PMI remained in expansion territory, easing to 52.3 in November from 53.3 in October. In response to further gains in new orders, Turkish businesses hired additional workers in November and the rate of job creation picked up to a seven-month high.
• Having stagnated during the early part of the year, fixed investment in Russia has picked up recently and grew to a nine-month high of 8.5 percent in September.  Allowing for a recovery in agricultural output following last year’s droughts, economists are raising their forecasts for GDP growth during the fourth quarter.
• The eurozone debt jitters could facilitate a banking consolidation process in Eastern Europe, giving the healthier banks a larger market share. Some of the Western European banks directly affected by the eurozone debt crisis have already sold their Polish subsidiaries to preserve capital for their core domestic operations.

Threats

• Spillover risks from the eurozone are growing. In Poland, the zloty’s steep fall has turned attention to public debt dynamics and inflation.
• While the U.S. Federal Reserve had been quick to turn on the money printing press when equity markets dropped in 2008, the European Central Bank (ECB) has been slow to respond to the eurozone periphery crisis.  But with the likely sources of funding not being sufficient to cover the size of the European bailout fund, ECB may have no choice but to expand its balance sheet.
• EU’s energy commissioner Gunther Oettinger has accused Russia of using energy as a political weapon. The commissioner sees the southern corridor route to deliver gas from the Caspian Sea as Europe’s best strategy, calling Gazprom’s South Stream pipeline a “new route for old gas.”

Past performance does not guarantee future results.

The MSCI Emerging Markets Europe 10/40 Index (Net Total Return) is a free float-adjusted market capitalization index that is designed to measure equity performance in the emerging market countries of Europe (Czech Republic, Hungary, Poland, Russia, and Turkey).  The index is calculated on a net return basis (i.e., reflects the minimum possible dividend reinvestment after deduction of the maximum rate withholding tax). The index is periodically rebalanced relative to the constituents' weights in the parent index.  The MICEX Index is the real-time cap-weighted Russian composite index.  It comprises 30 most liquid stocks of Russian largest and most developed companies from 10 main economy sectors.  The MICEX Index was launched on September 22, 1997, base value 100.  The MICEX Index is calculated and disseminated by the MICEX Stock Exchange, the main Russian stock exchange. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. Holdings in the Eastern European Fund as a percentage of net assets as of 12/31/2011: Gazprom 9.28%.