Investments

Don't put all your eggs in the US basket

The economic picture around the world has dimmed. But there are still potential profits abroad.

By Leslie Kane
Senior Editor

Japan's in a slump. Argentina's economy is melting down. Markets in many other nations have tumbled. But believe it or not, it's still smart to invest in international stocks.

For one thing, 49 percent of all the cash invested in companies worldwide is in non-US stocks, so dismissing foreign investments would be a mistake. "Many leading firms are based outside of America," says Eleanor Marsh, vice president of international equities research with State Street Research, a mutual fund and investment firm in Boston. Such companies include Nokia, the Finnish mobile phone company; GlaxoSmithKline, a British pharmaceutical company; and BP (British Petroleum).

As Europe's economy grows, owning shares of companies based there could boost your portfolio. So could investing in Japanese companies, if Japan's economic reforms succeed. If the euro and yen strengthen against the dollar, you could see even greater profits.

You could also benefit from other foreign markets that are already posting solid returns. For instance, through mid-May, the Morgan Stanley Capital International index for Korea, which tracks the Korean stock market, shot up 31.0 percent, and the MSCI Mexico index rose 12.1 percent.

Equally important, reaching beyond our borders helps protect your portfolio, because foreign stocks respond to factors that don't affect—and aren't affected by—the US market. That separation is particularly comforting given the US' large trade deficit, says William Howard, a financial adviser in Memphis. "If foreign investment in the US declines, the dollar and US financial assets could come under pressure," he says. "Holding foreign stocks partially protects investors in this scenario."

While foreign investing clearly brings advantages, you'll do best to buy through a mutual fund. That way, portfolio managers make buy-and-sell decisions, track down the most promising companies, find information that's not readily available to US investors, and sort out the complex tax and currency ramifications associated with their stocks.

Even using a mutual fund, though, you run the risk that you won't be able to escape what Wall Street's doing. Companies' global expansion and the increase in world trade have tended to make foreign markets move more in step with the US market in recent years. For example, the UK and US markets moved in tandem 74 percent of the time from 1997 through 2001. To reduce that likelihood, steer clear of "global" or "world" funds, which normally invest 25 to 50 percent of their assets in US companies, many of which you may already own. Favor funds that invest primarily in non-US companies, as do most funds identified as "international" or "foreign," for instance. To see what percentage of non-US holdings a fund can buy, read its prospectus.

Another way to reduce the chance of closely tracking the US market is to seek out funds that focus on areas other than large-cap growth companies.

Nondomestic investments should comprise about 10 to 15 percent of your portfolio. Invest less if you'll need the money in, say, five years rather than 20, or if the risk of losing money makes you unbearably nervous.

Here are some ways to make your foreign investing most effective.

An all-in-one fund makes foreign investing easy

The simplest way to invest abroad is to choose one international fund that captures most significant non-US markets. One option is an international index fund that holds a sampling of stocks from indexes that track several countries. For example, Vanguard Total International Stock Index Fund tracks the Morgan Stanley Capital International Europe, Pacific, and Select Emerging Markets Free Indexes. Its returns are virtually identical to those of the MSCI EAFE (Europe, Australasia and Far East) index.

Look, too, at exchange traded funds that track foreign indexes. Exchange traded funds are not mutual funds in the traditional sense, but are hybrids that combine features of stocks and mutual funds. They trade on stock exchanges, mimic stock indexes, and are passively managed like index funds. For instance, iShares exchange traded funds, issued by Barclays Global Investors, offers exchange traded funds that track the MSCI EAFE Index and the MSCI EMU (European Monetary Union) Index, as well as individual country indexes.

If you think index fund returns are too tame, look for an actively managed international or foreign fund with a record for beating its benchmark index. Two whose total returns have beaten the MSCI EAFE Index are Artisan International Fund, which topped the index by 6.1 percentage points over 12 months and an average of 12.3 percentage points annually over five years,* and Fidelity Diversified International Fund, which surpassed the index by 9.5 percentage points and 8.1 percentage points, respectively, over the same time frames.

Artisan International's portfolio managers focus on companies with dominant or increasing market share in strong industries, and avoid countries with overpriced markets. Most of the fund's assets are now invested in European companies. Top holdings include UBS, a Swiss financial company; Compass Group, a British catering firm; Telmex, the primary phone company in Mexico; and the Spanish retailer Inditex Group.

Fidelity Diversified International Fund held up well during the recent market slumps, partly because it has kept technology holdings to a small percentage of assets. Its managers are upbeat about investments such as Novartis, a Swiss pharmaceutical company, and ING Groep, a financial company based in the Netherlands.

The State Street Research International Equity Fund narrowly underperformed the MSCI EAFE's one-year return but beat that benchmark over five years. The fund invests in emerging growth companies as well as larger, established companies. Its top industry concentrations are energy, electrical and electronics, and forest products and paper.

One fund is good, two could be better

For potentially higher returns, you can team up two international funds. Keep half of your foreign allocation in a fund that covers the whole international market, as discussed earlier, and stash the other half in an international value fund. You'll add an asset class with hot prospects and minimal correlation with the US market.

Like their US counterparts, managers of international value funds invest in companies that have sound fundamentals but are temporarily out of favor and have depressed share prices. Value funds often perform relatively well when growth funds slump, and vice versa.

Foreign value funds never reached the 1999 heights of foreign funds overall, many of which invested heavily in growth companies—but neither did they take a precipitous fall when growth stocks tumbled. For instance, in 2001, when foreign funds as a group dropped 21.9 percent, foreign value funds fell only 14.4 percent. True, it's nothing to crow about—unless you were watching portfolios with only large growth funds plunge further than you were.

William Howard recommends the Longleaf Partners International Fund. Longleaf Partners International Fund has a right to cheer. It has suffered no losses since its inception in 1999, even as world markets have struggled. It's an extreme value fund whose managers buy only companies trading at prices at least 40 percent below their intrinsic values. In 2000 and 2001, the fund trounced all other foreign stock funds. It holds only about 25 stocks and aims to keep them for the long run, so the managers choose their investments carefully. Current investments include Nippon Broadcasting System, a Japanese communications company, and Renault, a French auto manufacturer.

Returns for the Oakmark International Fund have been outstanding this past year. The portfolio's in the top 3 percent rank within its category. Holdings are concentrated in Europe, with some in the Pacific Rim and Latin America. Portfolio managers recently bought several media and advertising companies, such as Wolters Kluwer, a Dutch publisher, and British marketing communications company Cordiant Communications Group.

Small companies, single countries can pay off big

Funds that focus on small companies present another option for diversification. Small-cap international businesses don't rely on American customers, and they respond to factors that don't affect the US market. Top selections include Oakmark International Small Cap Fund and First Eagle SoGen Overseas Fund. Both have returns that are above-average for the foreign small-cap group.

Oakmark International Small Cap Fund's managers hunt for cheap and promising small companies throughout the world. They picked up bargains in hard-hit Japan last year, and also boosted their stakes in several European companies. Small-cap value stocks were the world's best performers in 2001, and the fund is well positioned if value stocks continue to outperform.

Managers at First Eagle SoGen Overseas have a slow-but-steady approach. The fund's long-term returns are among the best in the foreign small-cap stock group, although it occasionally lags its growth- or sector-oriented rivals.

You might also consider zooming in on one geographic area. Some countries are rocking. The country index for Korea, as mentioned earlier, returned 31.0 percent year to date

Others, such as Australia, Taiwan, and Brazil, are less appealing based on their year-to-date returns (6.5 percent, ­1.0 percent, and ­2.6 percent respectively). Still, investing in these countries can help protect your portfolio, because the movements of their markets often don't track those of the US market. Brazil, for example, was in sync with the US only 58 percent of the time from 1997 through 2001.

"Korea and Taiwan have strong local economies and good fiscal and monetary policies," says Andrew Clark, a research analyst with Lipper, a mutual fund analysis company in Denver. "In addition, both countries export a lot of goods. As the US economy recovers, Korea and Taiwan are likely to outperform nonexport countries."

The Matthews Korea Fund, an impressive performer, is broader and more diversified than its rivals. Several of the funds' picks have soared in the past year. And because fund managers avoid too much concentration of assets in one company, a drop in any particular holding did not drag down the entire portfolio.

Adds Clark, "Australia is a major gold supplier, and natural resource firms, especially mining, have done spectacularly well. So have banking companies, because the Australian central bank dropped rates throughout 2001. The only negative is that, since 1997, the Australian dollar has fallen against the US dollar." So large profits to Australian companies won't necessarily translate back to equally impressive gains when converted into US dollars. The best ways to join the action are through a country mutual fund or an iShares exchange traded fund that tracks a country index. You can buy iShares ETFs for 33 country or regional indexes.

But keep in mind that by focusing on one country rather than diversifying, you're assuming more risk. "If you bet right, you're really right, but if you're wrong, you get hammered," says William Howard. You should feel strongly about a particular country's prospects and have the stomach to weather increased volatility.

*All fund returns as of May 21, 2002.

Top funds that invest abroad

These funds, which invest in companies based in countries whose markets don't move exactly in sync with the US equity market, will help you diversify your portfolio. Choose one general fund, or for greater potential returns and additional diversification, put half of your allocation into a general fund, and the other half into a value, single-country, or small-cap fund. We look here at the 3-month return to give you a picture of the fund now, after the initial repercussions from Sept. 11 had a chance to settle down.

¹As of May 21, 2002. ²Figures are annualized. N.A.: not applicable. All funds are no load except First Eagle SoGen Overseas Fund—Class A, which has a 5 percent front-end load, and State Street Research International Equity Fund, which has a 5.75 percent front-end load.

Leslie Kane. Investments: Don't put all your eggs in the US basket.

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