The Myth of Going Overseas for Diversification

You did what they told you and you lost a lot of money.

Asset allocation models -- the candy-colored pie charts in fund brochures telling you how much of your money you should invest in different types of stocks or bonds -- routinely tell us to put 20% or so of our money in international stocks. The stated reason: These markets, while often less closely regulated or liquid than ours, tend to go up and down differently than U.S. stocks, offering us diversification.

Translation: These markets can keep you from feeling the full brunt of a sagging U.S. stock market's occasional wrath. But this year U.S. growth funds and tech funds -- investor favorites -- are underwater, and the average foreign or global fund is tanking too. This situation has led many investors to ask, in classic Bronx fashion: What gives?

Innocents Abroad Investors who thought foreign and global stock funds would shelter them from a downturn in domestic big-cap growth stocks have gotten a rude awakening this year.
U.S. Large-Cap Growth funds	Foreign Stock funds	Global funds
-2.5%	-16.32%	-9.3%
Source: Morningstar. Performance figures through Oct. 23.

Yes, foreign funds are tanking this year, but the argument that a dollop of foreign stocks can reduce your portfolio's volatility while slightly boosting its returns is based on a long-term portfolio -- many years, not months. A look at the numbers shows that this line still holds up, so it does pay to own foreign funds after all -- if you're a long-term investor. Let's examine the argument for foreign funds, including some understandable misperceptions many of us have about them, and then discuss some ways you can best diversify a portfolio stuffed with U.S. growth stocks.

For years, marketers hawking foreign funds have said adding foreign stocks can boost your returns -- and they're not pulling your leg, according to Bryan Olson of Charles Schwab's Center for Investment Research, who crunched the numbers for us.

The data might not knock you over, but they do prove the point. Over the last 30 years, an all-U.S. portfolio would've averaged a 13.7% annualized return, using the S&P 500 to represent the U.S. market. An all-foreign portfolio would've posted a 13.2% return with more volatility, using the Morgan Stanley Capital Europe Asia Far East index as a foreign-stock proxy.

But a 75% U.S./25% international portfolio posted a 13.9% annualized return, topping the pure U.S. or pure foreign portfolio. That same portfolio had 8% less volatility in its returns from month to month, according to Olson and his colleagues.

For instance, in its worst month, the crash month of October 1987, the all-U.S. stock portfolio lost 21.5%, compared with a 19.6% loss for the blended portfolio. And in the foreign stocks' worst month, November 1973, they lost 14.4%, compared with an 11.8% tumble for the blended portfolio.

"What these numbers tell you is that you can lower your risk and increase your return," says Olson.

They also highlight a point that's often lost on investors -- rarely do U.S. and foreign stocks head in different directions. Instead they rise and fall together, just in different degrees.

As more and more U.S. investors trot further out on the growth/tech-stock tightrope, many have twisted the foreign fund argument into thinking that when domestic growth stocks get shaky, foreign stocks will be the net that catches tumbling investors. Great idea, but it's just not true.

"A lot of people presume diversification means that if U.S. stocks go down, foreign stocks go up, but that will almost never be the case," says Morningstar senior analyst Kunal Kapoor.

Agreeing to Disagree U.S. and foreign stocks have generally gone up and down together in the 1990s, but to vastly differing degrees.

Source: Baseline and Morningstar. Performance through Oct. 23. U.S. stocks represented by the S&P 500 Stock Index and foreign stocks represented by the MSCI EAFE Index.

Some have posited that the globalization of the U.S. economy has led to higher correlation between U.S. and foreign stocks. But that's not the case. Olson's data indicate that U.S. and foreign stocks tracked together about half the time in the 1990s. That's the same correlation they had in the 1980s and 1970s.

But in the short term, it can seem like U.S. and foreign stocks are peas in a pod. That is partly due to the fact that investors' U.S. growth funds and foreign growth funds have made big bets on the same companies, like Finnish cell phone titan Nokia(NOK) and British competitor Vodafone Airtouch(VOD), in addition to Canadian networking darling Nortel Networks(NT). This year's downturn is just natural cooling after last year, when the average foreign fund posted a 44.7% return, more than doubling the S&P 500.

For a more diversified slice of the foreign market, do-it-yourselfers might look at the no-load (VGTSX)Vanguard Total International Stock Index fund. The fund, a blend of the three Vanguard foreign index funds, has a modest 10% tech weighting, according to Morningstar. If you work with a broker, you might check out the broker-sold (TEMFX)Templeton Foreign fund, another lower-octane foreign choice.

If you're after diversification at all costs, you might take a look at foreign small-cap funds. Smaller companies tend to have more local customers, insulating them from global market trends.

"Small-cap international stocks really do move differently than U.S. stocks. They do give you more exposure to local markets," says Phil Edwards, a managing director at S&P's funds unit.

But there might not be a more dangerous pool to fish in than foreign small-caps, so for most investors it's probably best to have no more than a 20% allocation to foreign stocks through a broad core international fund. For some possibilities, check out this Big Screen that focused on foreign funds. For even more shelter from the market's tempest, check out this pack of core multisector bond funds that might do the trick.

After all, if you really want a diversified portfolio that doesn't get pneumonia whenever stocks get a cold, you can't afford to ignore the bond slice of this candy-colored allocation pies.

By the way, I'm not immune to foreign funds' current drubbing. Just over 14% of my nonretirement portfolio is sunk into foreign stocks. I bought my core international holding, (PINOX)Putnam International New Opportunities, five years ago when I worked for Putnam Investments. In that time, the fund has posted a 15.6% annualized return, beating 89% of its peers, and last year it rode a fat tech/telecom weighting to a 105% return. This year those same stocks have taken their toll. The fund is down more than 28% since Jan. 1.

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Over the last month, several tech and growth fund managers, including Villanova Capital's Aaron Harris and Merrill Lynch's Paul Meeks, have professed their love for Flextronics International (FLEX), a Singapore-based contract manufacturer of electronic components. Essentially, big companies like Cisco Systems, Motorola and Ericsson pay Flextronics to handle some or much of their manufacturing needs -- assembling cell phones or network equipment or other techy stuff.

While the pros know the company and the sector -- led by biggie Solectron -- pretty well, folks on Main St. may soon be hearing more about this company for the first time from talking heads on CNBC and the like. So let's look at it.

The stock is up more than 70% this year, according to Baseline, and is averaging a 68.4% annual gain over the last five years. Two years ago, only 4% of large-cap growth funds owned shares, but today that number is up to 15%. Over the last three years, the number of big-cap growth funds owning shares has risen every quarter, according to Morningstar -- indicating a growing following among the pros.

The firm's most recent earnings results beat analysts' expectations and it got a rave review from Banc of America Securities analyst Paul Fox at the B of A Conference in September.

"I think the long-term growth prospects are solid for FLEX," says Jay Ritter, the analyst who covers the company and its competitors for Morningstar, which doesn't do any investment banking. "They've got a diverse business mix and a diverse customer list. They just signed a deal with Motorola that will give them quite a bit of growth over the next few years. They can compete on cost because most of their plants are in low-cost areas like Mexico, China and eastern Europe."

But it's not tough to throw some water on Flextronics. Ritter admits that despite the company's low labor costs, profit margins are a concern. He also wonders if the company paid too much for acquisitions, and slowing growth for its customers would be a blow.

Also, the company's stock is currently selling at a 53.1 price-to-earnings multiple, compared to 25.3 for the S&P 500.

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Not a fan of fast-trading, high-octane CGM Funds manager Ken Heebner? Check out this Heebner bash site, which pushes investors toward less-aggressive fare, calling Heebner the "Mad Bomber." Because Heebner runs a real estate fund and this site is the work of HERE Research, a.k.a. the Hotel Employees and Restaurant Employees International Union, one might wonder if the friendly folks at HERE are have ulterior motives.

And if you'd like to let Roger Clemens know what you think of his World Series emotional meltdown, here's the official Rocket Roger Web site, which is appropriately rife with typos. There you can send the hard-throwing Yankee starter a public or private message. The site's store isn't running these days, but on eBay you could've bought this bat, which purports to be autographed by the enigmatic future first-ballot Hall of Fame shoo-in.

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