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| The Basics | Why you should go for more global funds
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At least one strategist is calling for foreign stocks to outperform U.S. equities over the next 10 years. Here's how you can diversify with foreign funds -- and increasingly, global funds that also include U.S. stocks.
By Timothy Middleton
In the long run, foreign stocks are supposed to do roughly as well as domestic ones. But in the long run, as Lord Keynes famously observed, were all dead.
Foreign investments have been in rigor mortis since 1995, a victim of Americas one-two punch -- a strong economy and mighty dollar. But it hasnt always been that way. From 1983 through 1988, they trounced U.S. stocks: In 1986, the margin was a gain of 69.9% over the U.S. advance of 18.5%. And the odds are with them again.
The core themes that drove the American economy in the 1990s are now spreading to the rest of the world. Even in the labor union-dominated capitals of Europe, corporations are wringing greater productivity out of their workers, as well as out of their machines. Deregulation is prompting competition, which is fueling consolidation, which in turn leads to greater efficiencies as stronger companies take over weaker ones.
In Asia, the tigers of the Pacific Rim have largely righted their tottering economies. China is slowly transforming itself from a centrally planned economy to a market economy.
Foreign funds finding their own way
Historically, investors brought international flair into their portfolios in the form of mutual funds that owned only non-U.S. companies. Foreign-stock funds continue to dominate the field, but they face competition from so-called global funds, which own domestic as well as overseas securities.
Global funds have the intellectual appeal that the world increasingly is becoming a single marketplace. But fitting them into a portfolio can take special care. Their domestic holdings, especially large companies, might overlap with the global portfolio.
You have to look at your overall portfolio and make sure youre diversified enough, says Paula Boyer Kennedy, a financial planner with Joel Isaacson & Co. in New York.
Over the last 32 years, according to Ibbotson Associates, foreign and domestic stocks have performed similarly. In that time, the Standard & Poors 500 Index ($INX) delivered annualized returns of 12.1%, compared with 11% for Morgan Stanleys Europe Australasia Far East Index, or EAFE, benchmark.
In the 1990s, however, foreign issues not only performed worse than domestic stocks, they also provided little diversification benefit, going up with domestic equities and down with them, also. That wrong-way reinforcement reached a crescendo last year, when EAFE tumbled 21.2%, or nearly twice as much as the S&Ps 11.9% decline.
During 2002, however, foreign funds uncoupled from domestic portfolios. The average international fund advanced 1.9% in that year through April 26, compared with a loss of 8.9% for domestic large-cap growth funds, according to Morningstar. Japan was on a tear: up 12.3% in dollar terms in 2002 through April 26.
Why go global?
The principal argument for a global, rather than foreign, fund is that the worlds leading companies are domiciled all over the place.
Why be forbidden from going anywhere? asks Frank Jennings, manager of Oppenheimer Global Opportunities (OPGIX), which has delivered annualized returns of 14.3% in each of the last 10 years. Good ideas are hard enough to find.
Moreover, markets themselves are increasingly global. He cites the example of Porsche (PSEPF, news, msgs). The automaker is headquartered in Germany, but its largest market, accounting for 40% of total sales, is the United States.
The Oppenheimer fund hews to a 50/50 mix between foreign and domestic stocks; thats roughly in line with the total capitalization of the worlds markets. That blend also has the fortunate effect of muting the volatility of individual markets, providing what Jennings calls a smoother ride.
Reducing volatility allows Jennings to be more aggressive in his individual stock picks than he would otherwise be.
You cannot make money without taking risk, he says. His funds average market capitalization is $5.8 billion; the category average is more than $22 billion. Small stocks tend to be riskier than large ones, but their returns can be correspondingly high.
Dividing your efforts
In the foreign-only camp is Fidelity Diversified International Fund (FDIVX), the flagship foreign fund of the nations largest fund complex. Its 10-year record is annualized returns of 12.3%.
Manager William Bower says he has invested a portion of his own assets in his fund, while putting his domestic investments into U.S.-only funds. Its hard to ask one person, or one group, to do the whole world, he says. Fidelity has 200 foreign-stock analysts who follow 7,000 companies. I think its better to own foreign and U.S. funds, he says.
The Fidelity fund is positioned to take advantage of what Bower believes will be economic catch-up in the coming decade. Restructuring was a powerful force that led the U.S. market to outperform the rest of the world in the latter half of the 1990s, he says. Youre starting to see that creep into other parts of the world. Youre in the second or third inning there.
The restructuring granddaddy of them all would be the transformation of Japan from a manufacturing to a service economy, the manager says. Thats why people would want to be interested in diversifying a U.S. portfolio to include international stocks.
How much should you allocate?
Kennedy usually puts her clients into foreign-only mutual funds, to eliminate overlapping holdings with domestic funds. But she notes a global fund doesnt necessarily create that problem. The Oppenheimer fund, for example, owns relatively few large-capitalization domestic names and therefore wouldnt overlap an S&P 500 index fund.
She also recommends putting no more than 15% of your equity assets into foreign stocks, arguing that figure produces the greatest diversification benefit with the least additional risk. My colleague Mary Rowland has long argued your allocation should be 0%, both because foreign markets have behaved so poorly, and because big U.S. companies rely so heavily on foreign sales, you automatically get exposure through them.
My own allocation has been about 20% recently. Markets go through cycles. It wasnt too long ago that U.S. stocks looked crummy compared with Japanese equities. Sooner or later the United States will surrender its leadership; it may be doing that already.
And if foreign economies begin to do better, their currencies will strengthen against the dollar, giving an added boost to foreign-fund returns. Currencies go through cycles, too.
At the time of original publication, Timothy Middleton didnt own any of the securities mentioned in this article.
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