Why Foreign Stocks Mean Opportunity


With the hot performances of Asian, Latin American and other foreign stock markets this year, many U.S. investors are suddenly interested in global investing again.

But are foreign stocks an asset class that you should always be in, with at least part of your portfolio?

That has been a subject of great debate in recent years, with some financial advisors arguing that Americans don't need foreign stocks.

The long-standing argument for foreign investing--the idea that foreign markets don't correlate that closely with the U.S. market, so that the former offer a buffer against a U.S. downturn--is no longer viewed as solid reasoning.

Last year, Morningstar Inc., the Chicago-based fund tracker, examined the performance of "foreign" and "diversified emerging-markets" funds during slowdowns in the U.S. markets.

In the 10 years leading up to the study, Morningstar identified 12 months in which the benchmark Standard & Poor's 500 index of blue-chip stocks fell 3% or more.

In 11 of the 12 cases, the average foreign fund (which tends to have a heavy concentration of European and Japanese stocks) fell in sync with U.S. stock funds.

And on all 12 occasions, the typical diversified emerging-markets fund fell, often losing more than U.S. stock funds.

These results confirm that the world is more in sync with U.S. markets than ever before, thanks to trends such as advances in technology and communications, and the lowering of trade barriers.

David Masters, senior analyst with Standard & Poor's Fund Services in New York, has been looking at the correlation of global stock funds with the U.S. markets for years. He notes that five years ago, movements in foreign stock funds had a correlation of about 52% with the movements in the U.S. stock market. Today, it's closer to 82%.

Five years ago, the average emerging-markets fund had a correlation of just 40%. Today, the figure is 80%.

Nonetheless, although it's not as dramatic as it used to be, foreign stock investing still provides a risk-reduction benefit, argues Leila Heckman, managing director in charge of global asset allocation for Salomon Smith Barney in New York.

A more compelling argument has to do with opportunity, says Heckman: There are 2,728 medium and large companies in the world with a market capitalization of $1 billion or more. Yet only 1,634 of them are found in the U.S.

"The rest of the world represents 50%-60% of the world's market capitalization," says financial planner Harold Evensky of Coral Gables, Fla. "It seems pretty myopic and provincial to ignore that in your portfolio."

Yet from 1994 through 1998, as U.S. markets far outperformed those of other nations, many Americans--indeed, even a sizable number of pros--were satisfied to keep their money within U.S. boundaries, arguing that a stake in American companies with profitable overseas operations was all the "foreign" a portfolio needed.

They were right in that time frame. But if they stuck to a U.S.-only strategy this year, they missed out on the 39% first-half gain for the typical Pacific region fund that does not invest in Japan, the 36.5% gain of the typical Japan fund, and the 28.9% gain of the typical Latin America fund.

And although European funds have disappointed this year, had you vowed not to invest in Europe over the past five years, you would have missed out on respectable gains of nearly 16% a year.

"1999 is great evidence that there are great companies in other countries that are market leaders as well as exciting small companies overseas that you'd miss out on if you completely cut off the rest of the world," says Gregg Wolper, international-funds editor for Morningstar Mutual Funds.

The underperformance of foreign stocks from 1994 to 1998, then, isn't an argument against investing overseas. It's an argument for investing overseas in a strategic, or opportunistic fashion, says Sheldon Jacobs, editor of the No-Load Fund Investor newsletter.

That means keeping a certain allocation abroad--say, 10% to 20% of your total investment portfolio, depending on your risk tolerance and the other types of stocks or stock funds you own.

Let's say you want to invest 15% of your overall portfolio overseas. One idea, planners say, is to split your foreign holdings into two groupings, with one getting a greater percentage of the allocation.

In the first group, you invest in the developed markets, either through a Europe fund, a Japan fund or, preferably, through a diversified foreign fund. Diversified foreign funds typically invest about two-thirds of their assets in Europe, but can shift more into other parts of the world, including Japan, should circumstances warrant it.

Let's say, then, that you put 10% of your portfolio in a combination of investments in the developed markets.

In the other group, assuming your risk tolerance will allow it, you put riskier, emerging-markets investments. This group may include Latin America funds, Asia funds or a diversified emerging-markets fund--depending on which region or regions of the world you have the most confidence in.

Some experts still argue that you don't need to be in emerging markets at all, given the volatility in those stocks and their paltry returns in the 1990s. In any event, the consensus is that no more than 5% of your total portfolio should be in emerging markets--say, in a diversified emerging-markets fund.

Now, whereas you may prefer a long-term "buy-and-hold" stance with your developed-markets funds, don't feel compelled to do the same with the funds in the second group, some experts say.

Why? Because emerging-markets funds can fall just as fast--if not faster--than they've shot up this year. Some experts say they're better suited as trades, not long-term investments.

One idea is to set a sort of mental "stop-loss" order on emerging-market funds. "You say, 'If the fund goes down this much, I'm out,' " advises Templeton Developing Markets manager Mark Mobius. And as the market rises, you keep adjusting that mental stop-loss order up with it.

In those periods when you don't feel comfortable in emerging markets--such as when they're in extended free falls, as Asia-region funds were last year--the idea isn't to shift that 5% out of foreign stocks entirely, but rather to shift it into a developed-market fund, so that you maintain your overall foreign-stock weighting, but with less risk.

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