Again, the Activity Was Overseas
Stock mutual fund investors made money for a third straight year in 2005. And once again, Americans scored the biggest gains by sending their cash abroad.
Funds that invest overseas trounced domestic funds for a fourth year. The average foreign stock fund produced a total return of 17.4% for the year, compared with a 6.7% return for the average U.S. fund, according to Morningstar Inc.
For many Americans, the percentage of assets held overseas has become the deciding factor between mediocre and spectacular investment returns in this decade.
And that is causing financial advisors to rethink classic guidelines about the proper mix of domestic and foreign shares in clients’ portfolios. Some say it isn’t outlandish to keep as much as 50% of an investor’s total equity assets in overseas funds -- far more than the 15% to 20% that was considered prudent in the 1980s and 1990s.
If they’re using the old rules, “I think most people are underinvested in foreign markets,” said Russ Kinnel, director of fund research at Morningstar in Chicago.
Scott Leonard, head of investment advisory firm Leonard Wealth Management in Redondo Beach, said he has split the typical client’s portfolio about 50-50 between U.S. and foreign shares since 1994.
“Americans look at foreign stocks as something ultimately more risky and dangerous than U.S. stocks. I just don’t buy that,” Leonard said.
Still, many veteran investors may remember foreign markets’ miserable stretch from 1995 through 2001, when U.S. shares beat foreign issues every year but one. That period encompassed the downward spirals of Japan’s economy and stock market, and some dramatic crashes in so-called emerging markets, including Mexico in 1995 and South Asia in 1997-98.
The struggles of many foreign markets in the 1990s may have fueled a kind of “misplaced nationalism” on the part of U.S. investors, Kinnel said.
But in this decade, nationalistic U.S. investing tendencies have been melting away in the face of some huge shifts in the global landscape.
One, of course, is the stunning rise of China’s economy, which has triggered boom times across much of Asia and lifted commodity prices worldwide, benefiting emerging economies that are exporters of raw materials.
Another is the U.S. dollar’s steep slide since 2002 against the euro, the Canadian dollar and many other currencies.
Some on Wall Street believe the dollar has been devalued because of the huge U.S. trade and budget deficits, which have in effect led to a glut of dollars around the world. Others say the currency became overvalued in the 1990s and that the decline in recent years was merely correcting some of that overvaluation.
Whatever the cause, the weaker dollar has given Americans another good reason to own foreign stocks: As other currencies appreciate, U.S. investors’ holdings of foreign assets are worth more when translated into dollars.
A case in point: Mexico’s stock market rocketed 37.8% in pesos last year. But because the peso also appreciated against the dollar, the market’s total gain for a U.S. investor was 44.5%.
That helped to put Latin American stock mutual funds in the top spot among 34 major equity fund categories tracked by Morningstar. The average Latin American fund soared 53.8% in 2005.
But the dollar can cut both ways. In 2005, the buck surprised many on Wall Street by recouping some of its 2002-04 losses against the euro and the yen. That hurt U.S. investors’ returns in European and Japanese stocks. The German stock market, for example, was up 27.1% in euros, but in dollars the gain was reduced to 11.1%.
Even so, the average European stock mutual fund gained 14% last year, more than twice the return of the average U.S. stock fund.
And so far this year, foreign markets again have a tailwind from a weaker dollar: A Bloomberg index of 500 European blue-chip shares is up 2.7% in euros and 4.8% in dollars, outpacing the 3.4% gain in the U.S. Standard & Poor’s 500 index.
Despite the fear U.S. investors may have that hot foreign markets are getting ahead of themselves, Wall Street generally can find more reasons to be optimistic than pessimistic about overseas economies and stocks:
* Unlike in the U.S., where some economists worry that overextended consumers may be cutting back on spending, the sense is that consumption is poised to increase overseas.
“Evidence is mounting that the U.S. economy is slowing while other economies, especially those of Japan and Europe, continue to improve,” said Joseph Carson, economist at Alliance Capital Management in New York.
* In Western Europe, “many governments are turning to tax cutting, in part to get their moribund economies moving, but more to compete with the new Eastern European members of the European Union,” said Milton Ezrati, senior economic strategist at fund giant Lord, Abbett & Co. in Jersey City, N.J.
With many investors still skeptical about Western Europe’s long-term growth prospects, “any reform could lead to the kind of positive surprises that can potentially propel equity markets upward,” Ezrati said.
* Japan appears to be rebounding from more than a decade of recession or near-recession and serious deflation. Alliance’s Carson noted that an index of Japanese manufacturing activity rose in December to a level that topped a similar U.S. index for the first time since early in 2003.
In a report Monday, Merrill Lynch & Co. told clients that it expected Japan in 2006 “to regain its place as one of the growth drivers for Asia, ahead of the U.S. and second only to China.”
* In many emerging markets, wealth generated by commodity exports is helping to fuel growth throughout those economies and lift many non-commodity stock market sectors as well.
Energy-related stocks were the single biggest gainers among 10 broad equity sectors of emerging markets last year, up 57.2% on average, according to Morgan Stanley Capital International. But the nine other sectors also rose by double digits.
Healthcare stocks in emerging markets, for example, were up 35.2% on average. Financial services shares were up 28.1%.
* Stock valuations, such as price-to-earnings ratios, remain reasonable in many foreign markets, analysts say. Although share prices have surged in this decade, they were rebounding from depressed levels after the 1990s, foreign-stock fans say.
Still, the powerful gains in most foreign markets over the last few years understandably may make many U.S. investors nervous about jumping in at this point -- and may cause some to think about selling.
Leonard, the investment advisor, said he believed that maintaining a 50-50 split between U.S. and foreign shares still made sense for investors who could take a very long-term view.
He has found that split to be “the sweet spot” in terms of boosting a portfolio’s return over time while reducing its volatility.
Robert Bingham, a principal at wealth management firm Bingham, Osborn & Scarborough in San Francisco, said he believed that many clients could justify having about 30% of stock assets in foreign shares now, instead of the 20% cap usually recommended in previous decades.
Part of his firm’s consideration, Bingham said, is a concern that “longer term, there’s going to be more pressure on the dollar.” As a way to preserve purchasing power, he said, “we think that means you have to have a good chunk of your portfolio in foreign currencies -- not just in foreign stocks but also foreign bonds.”
Morningstar’s Kinnel said he also was comfortable with investors’ having as much as 30% in foreign shares, depending on their risk tolerance.
Investors who want to raise their exposure to foreign shares but are wary of buying into the current hot streak could simply wait for an inevitable pullback, of course. The problem is that timing market swings usually proves to be difficult, if not impossible, for the average investor.
Kinnel offered another idea: Investors who have 401(k) retirement accounts and who have a foreign stock fund in their plan could shift their allocation of new savings so that more dollars go to the foreign fund and less to other plan options, he said.
On the other hand, he said, investors who are heavily invested in foreign funds and who want to take some profits there would be justified in shifting money toward some depressed U.S. fund sectors that have shown signs of turning around recently -- for example, blue-chip funds and those that focus on shares of growth-oriented industries such as technology.
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Another hot year
Gains in major market indexes in 2005 in local currencies (actual) and in U.S. dollars
*--* Country Actual In U.S. dollars S. Korea +54.0% +57.8% Brazil +27.7 +45.2 Mexico +37.8 +44.5 Canada +21.9 +26.1 Japan +40.2 +22.1 Singapore +13.6 +11.6 Germany +27.1 +11.1 France +23.4 +7.9 Britain +16.7 +5.0 Taiwan +6.7 +3.3 U.S./S&P; 500 +3.0 +3.0
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Source: Bloomberg News
