Cutting to the Core of Overseas Investing

Even a basic international portfolio should include small-caps and emerging markets.
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By now investors who want a diversified portfolio know they should have a core international fund, but the idea of what that core fund should look like has changed as much as Wall Street's attitude toward overseas investing.

Rather than focusing on a basic large-cap international fund, investors should have small-caps and emerging markets as a core part of their portfolios, fund experts say, even amid recent outflows and risk worries.

This type of overseas buying is considered part of a long-term strategy, rather than about chasing momentum, says Quincy Krosby, chief investment strategist at Hartford Financial.

"On a secular basis, having emerging markets in a portfolio is important and crucial to a diversified portfolio because many top consulting firms have found that over the next 10 to 20 years, a good portion of the top global brand names will come from emerging markets," Krosby says. "An investor wants to be there early on for the chance to capture gains under a variety of conditions, and you can only do this by having a broadly diversified portfolio in international markets."

She also notes that McKinsey research has shown that China and India alone will be 50% of global gross domestic product by 2025. Meanwhile, U.S. growth has lagged behind many other countries for years. "We want clients to go in and establish a position in international investments when valuations are down and you have a safety margin," she says.

This is not necessarily easy advice for investors who have been shaken by the second-quarter stock slide and are now looking for less risk. The recent overall weak performance of international funds has made it difficult to find clear favorites.

"Nothing really stands out right now," says James Peterson, vice president of mutual fund research at the Schwab Center for Investment Research.

Even so, money should still flow to overseas stocks, says Bill Rocco, senior analyst with Morningstar who specializes in emerging-market and international funds. "There's a tendency to overreact to short-term events

like the second-quarter stock selloff. What people should have done, and should do, is build a good multi-fund international portfolio that uses dollar-cost averaging and rebalancing as necessary."

The New Core Portfolio

The MSCI Europe Australasia Far East index is the benchmark for most of the funds that traditionally have been considered core international funds. It's a large-cap index that focuses on developed countries.

Many analysts say that investors should check an international fund's performance against this index much in the same way they would check a fund that holds domestic stocks against the

S&P 500

.

For example, the

(SSAIX) - Get Report

State Street Global Advisors International Stock Selection fund concentrates on investments that are included in the MSCI EAFE. The fund, which has a five-year total return of 12.41% vs. 10.02% for the EAFE, aims for diversification across countries and sectors and is benchmarked-oriented.

But solely owning that type of fund might not be enough of an international holding, says Peterson.

"Generally, when you say 'core' you're talking about large-cap developed-country funds that mimic the EAFE," Peterson says. "But it's actually a mistake to limit yourself to this type of core international holding because those large-cap international stocks have become more correlated with U.S. equities over time ... so the benefits of diversification are not as good as they used to be."

He says investors must expose themselves to all markets by having allocations in large-cap developed markets, small-cap international equities and emerging markets.

Rocco agrees that investors won't get the true benefits of diversification without some exposure to these areas.

"Make sure that your international and domestic portions of your portfolio don't leave you overexposed to certain styles and sectors, or if you are overexposed that you are conscious of what that that means," Rocco says.

Moreover, Rocco notes that core international funds should correspond accordingly with your domestic holdings. "If you have all value stocks

in your domestic holdings, maybe it would be a good idea to go with a blend or growth international fund."

The

(SWOIX)

Laudus International MarketMasters fund, which has a four-star rating from Morningstar, is a foreign large-cap growth fund. These funds tend to divide assets among a dozen or more developed markets, including Japan, Britain, France and Germany and invest the rest in emerging markets, such as Hong Kong, Brazil, Mexico and Thailand. They typically have less than 20% of their assets in U.S. stocks.

As for single-country funds, Rocco says average investors don't need to take the risk.

"They are for people who already have a well-balanced portfolio in international funds who want to make a stock-like investment in terms of risk/reward," he says.

The Right Mix

So how much international exposure is enough? Peterson suggests having 25% of one's overall equity exposure in international funds. Of that amount, he says he would have five percentage points in emerging markets, five percentage points in small-cap international stocks and the remainder in large-cap companies in developed companies.

But these percentages are not set in stone. Peterson says that in the near term, he would slightly underweight international funds "only because of the geopolitical uncertainty right now and uncertainty about worldwide interest rates."

Krosby adds that international investments are more complicated because there are political and transparency issues involved. "That's the reason we recommend a good mutual fund, as opposed to buying individual

international stocks," she says. "Leave the work to a good portfolio manager and analysts on the ground to follow the trends in that country."

This work is also why you pay more in fees for an international portfolio, and analysts at Morningstar say it's important to watch out for the fees.

Actively managed international funds carry average expenses of 1.2% vs. 0.3% for most index funds.

Rocco says to think about the big picture, not just what has done well recently.

"Fund styles go in and out of fashion," he says. "Look at the long-term performance and focus on how well the fund did when it was out of favor, as well as how it did when it was in favor."