Foreign Funk: Don't Ignore Those Overseas Funds

Few people are buying international funds nowadays, but going contrarian can pay off.
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U.S. fund investors have all the wanderlust of

Archie Bunker these days -- and that's not good.

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Most candy-colored asset allocation pies tell us to put 20% of our stock portfolio in foreign stock funds. Over time, the thinking goes, holding these funds should boost returns and reduce risk because a rally overseas can help offset a sagging home market.

Following this strategy has paid off historically but not recently: Foreign fund sales have dropped sharply since the mid-1990s, when U.S. stocks' growth accelerated. Heightening the jingoistic trend, overseas funds slipped into net redemptions last year for the first time since 1988, according to Boston fund consultancy Financial Research Corp.

Still, these funds are tough to ignore if you look beyond the market's wild swings of the past five years.

"People just look at recent performance and figure, why bother?" says Bryan Olson of the Charles Schwab Center for Investment Research. "There will again be times when it's beneficial to own foreign stocks, and people will be glad they have exposure," says Scott Cooley, a senior fund analyst at Chicago research house Morningstar.

Few investors seem to share that view. From 1992 through 1996, foreign stock funds captured 13% of stock-fund net cash flows, according to FRC. But in the past five years, that figure has fallen to just 5%.

Starvin' Marvin
Fund investors keeping their money here

Source: Financial Research Corp.

For that the foreign funds can thank the U.S. market, which had its best five-year stretch ever from 1995 through 1999. The average overseas fund, weighed down by a strong U.S. dollar, currency meltdowns and a slowing global economy, has beaten the

S&P 500

just twice in 10 years, according to Morningstar. How bad has it gone for the imports? Well, over the past five years, the foreign stock-fund group trails

every

domestic stock-fund category.

Even believers acknowledge it's been tough to keep the faith.

"I still believe in the argument, but it's really tested investors recently with a long dry spell," says Nancy Flogge, a certified financial planner with American Express Financial Advisers in Hudson, Ohio.

It also hasn't helped that Jack Bogle, founder of the Vanguard Group and one of the industry's most widely respected shareholder advocates, has repeatedly

said that foreign stock funds aren't worth the potential for political and economic instability.

Lagging Behind
Foreign funds not keeping up

Source: Morningstar.

So foreign funds seem about as steady as Robert Downey Jr. on a Friday night -- but you ignore them at your peril. That's because if we look beyond the recent past, foreign stock funds' growth and diversification argument holds true.

In the 20 years up to 1995, foreign stock funds topped the S&P 500 10 times, according to Morningstar. A domestic portfolio with 20% of its money in foreign stocks would've topped an all-U.S. portfolio in 17 of the past 30 years, according to Schwab's Olson. He adds that over the past 15 years, the best-performing developed market has never been the U.S.

"People have just forgotten about foreign stocks' return potential," he says. Ignoring them is "just giving up on a large number of the biggest companies in the world," he adds.

Unflinching
Adding a foreign fund won't decimate returns

Source: Morningstar. Returns through Dec. 31.

Critics note that while big-cap U.S. and foreign stocks used to rise and fall in different cycles, they have begun to move in sync in recent years. That's because the line between domestic and foreign companies has blurred, thanks to multinational operations such as

Coca-Cola

(KO) - Get Report

and

General Electric

(GE) - Get Report

.

But splitting your foreign-stock exposure among big- and small-cap funds can address this problem. Foreign small-caps aren't well followed by analysts and are usually driven by more local issues and customers. That keeps them from tracking with broader indices. The bargain-hunting

(OAKEX) - Get Report

Oakmark International Small-Cap fund, for example, rang up a 13% gain last year, compared with losses of 22% and 12% for the average foreign stock fund and the S&P 500.

Then there's the idea that things may not always be so great here at home.

"Some in other countries have been sorely punished for investing in their own markets," says Morningstar's Cooley. "Even if there's just a one in a hundred chance that we could experience Japan's type of turmoil, why not guard against it?"

The bottom line is that long-term investors shouldn't write off a sector because of short-term results. For some viable options, check out today's

Big Screen.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.