‘Cushioning’ Effect of Foreign Diversification Called Into Question

What’s wrong with foreign stock markets--again?

In the third quarter and for the year to date, most foreign-stock mutual funds performed far worse than the typical U.S. stock fund.

The average foreign fund that invests worldwide lost 7.1% in the quarter and is down 10.7% year-to-date. By contrast, the average U.S. stock fund was up 2.6% in the quarter and 6.3% in the nine months.

Asian markets have been particularly hard hit this year by political, economic and interest-rate concerns. In Europe, the weak euro currency has slashed stock returns for U.S.-based investors.

Those foreign-fund figures have to be taken in context, of course: Last year was a great year for foreign markets. The average foreign fund rocketed 43.6% in 1999, more than double the return of the U.S. Standard & Poor’s 500 index.

Still, 2000 is on track to be the fourth year in five years that foreign stocks have lagged U.S. stocks.

That has called into question the “cushioning” effect that foreign diversification is supposed to provide for a portfolio that is mostly U.S. stocks.

“Many traditional forms of diversification don’t seem to work anymore because markets tend to move in sync,” said Kurt Brouwer of the Tiburon, Calif., investment firm Brouwer & Janachowski. “If the U.S. goes down, foreign markets may follow. And remember how the Russian problems [in August 1998] rocked our market too?”

Indeed, many investors say they don’t want any part of foreign investing.

“McDonald’s and some of the other blue chips cover the foreign aspect as much as I care to be a part of it,” says Pat Morgan, a 69-year-old investor in Westlake Village.

Nonetheless, it’s hard to find financial professionals who are willing to completely forgo having some chunk of their assets in foreign stocks, even if it’s no more than 10% or 15%.

Though the correlation between U.S. and overseas markets has increased in the last 20 years with the evolution of the global economy, many experts say it’s worth being in foreign markets to catch dramatic moves like last year’s.

And with the U.S. winding down from its phenomenal economic boom of the last five years, other parts of the world may be in for a stretch of relatively better growth, said Stuart Freeman, strategist at brokerage A.G. Edwards in St. Louis.

Whether that translates into better stock returns, however, remains to be seen.

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One Out of Five Isn’t Great

Investing overseas has been a bomb for four of the last five years, including this year through the third quarter. A look at how the average foreign fund (which typically invests in large foreign stocks) and the average emerging-markets fund have fared compared with the U.S. Standard & Poor’s 500 index:

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Avg. Avg. foreign emerging S&P; 500 Year fund mkts. fund index 1996 +12.2% +12.6% +23.0% 1997 +5.6 -2.2 +33.4 1998 +12.4 -26.5 +28.6 1999 +43.6 +71.4 +21.0 2000 YTD -10.7 -20.6 -1.4

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Source: Morningstar Inc.