Foreign-Stock Funds and the Benefits of International Diversification

In 2007, mutual funds specializing in non-U.S. stocks returned a fat 16%, while funds with diversified holdings in U.S. equities returned just over 6%. In fact, the foreign-stock funds have beaten domestic-stock funds over periods of two, three, five, 10 and 15 years, according to Lipper, the fund-tracking company.

On top of that, owning foreign stocks helps a U.S. investor diversify risk by reducing a portfolio's volatility , thus improving compounding over the long term.

Why is it, then, that so many surveys show that the typical U.S. investor does little more than dabble in foreign stocks? The average small-investor portfolio has 10% to 12% of its equity investments committed to foreign stocks, while many experts recommend 20% to 40%. "People tend to invest more in their local stocks," says Wharton finance professor Karen K. Lewis, adding, "There are big gains from diversification that people don't exploit."

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For insight into this, Lewis set aside questions about foreign stocks' returns, which vary widely, and focused on whether foreign stocks continue to dampen portfolio volatility as much as experts have thought. Perhaps investors have discovered they do not.

Lewis' findings are described in her December 2007 paper titled, "Is the International Diversification Potential Diminishing for Foreign Equity inside the U.S.?" She finds that foreign stocks' volatility-dampening effects have indeed diminished, but that they are still strong enough to make foreign-stock investing worthwhile. "The bottom line is that there still are benefits to international diversification in 2007 and 2008," she said.

But it takes some digging to prove it. "The first question has to do with: 'Have things changed?' " she said.

Advocates of foreign stocks have long argued that stocks in different countries march to different drummers. Thus, when U.S. stocks are down, stocks in Europe, Asia or Latin America may be up, and vice versa, making foreign holdings attractive.

The Globalization of Securities Markets

But in previous decades, foreign markets may have been more independent of the U.S. market than they are today. In the past, it could be hard for investors in one country to trade stocks of another. One might need an account with a foreign brokerage , or with a domestic one having overseas operations.

Even if this problem could be overcome, it would often be difficult to research foreign stocks or to know what the data meant. Many countries, for example, do not follow the accounting and reporting standards U.S. investors are accustomed to. "People have argued that it's hard to diversify because it's harder to get information about foreign companies," Lewis said

Globalization of the securities markets has changed this. Today, U.S. investors can choose among some 3,000 mutual funds and exchange-traded funds that hold foreign stocks. They can leave the research to the pros by investing in managed funds , or they can match the performance of markets in specific countries or regions by purchasing index-style funds and ETFs . And while changing exchange rates can affect returns , investors don't have to worry about converting dollars to yen or euros; they can do all their foreign-stock investing in greenbacks.

Bottom line: Convenience is no longer an obstacle to foreign-stock ownership.

But some experts theorize that this ease-of-investment has reduced the benefits of foreign stocks because it has caused stocks around the world to march in unison. This could diminish the volatility dampening long thought to be a benefit of foreign investing.

"This is fairly accepted conventional wisdom -- that the U.S. and foreign markets have higher co-movement," Lewis said. Certainly that is evident in the worldwide stock slump at the start of this year. An international investor worried that the subprime mortgage mess will depress U.S. stocks may, for example, cut back on any investment deemed risky -- in the U.S. and overseas.