Foreign stock ownership is becoming less and less of a foreign concept in this country. Companies ranging from
have made their mark far from home.
But beyond the big names, overseas stocks -- and the mutual funds that focus on them -- continue to hold some mystery. Getting past that is important, since anyone looking to build an investment portfolio using the asset allocation model is going to need some foreign stock exposure. (See last week's first two installments in the asset allocation series, on
Most financial advisers recommend a foreign stock allocation for their clients' portfolios. Some recommend as much as 20%, depending on risk tolerance. And because of the constraints surrounding the purchase and sale of most individual foreign stocks (i.e., time differences, costs, etc.), most investors are far better off in mutual funds with experienced managers rather than attempting to navigate European or Asian bourses alone.
When it comes to shopping for a foreign stock fund, Morningstar analyst Bill Rocco says the same basic principles for choosing domestic funds -- strong performance history, low fees, experienced management -- apply for foreign funds.
"People surround foreign funds with a great deal of mystery," says Rocco. "But the reality is that it's no more complicated or difficult to select a foreign stock fund than it is to find a domestic stock fund."
One area of foreign funds that is often unfairly hyped is their cost. According to Morningstar, the average expense ratio for an actively managed foreign fund is 1.7%, compared with 1.5% for a domestic fund. However, Rocco says investors need not be intimidated, as there are good funds available for less than 1.5%. Take his top pick, the
Tweedy Browne Global Value fund, which carries an expense ratio of 1.4%.
Investors scared off by the specter of higher fees would surely kick themselves if they saw the reality of foreign fund returns. Year-to-date returns in foreign large-cap value funds are 10.39%, double those of similar domestic funds. And diversified emerging markets funds have returned 9.1% this year, tripling the
and demonstrating that there is much money to be made from globe-hopping.
The wide difference in returns between foreign and domestic funds clearly demonstrates the importance of geographical diversification. While some countries' economies are booming, others will be busting. That's why it's a safer bet for investors to spread their chips around the globe instead of pinning their hopes on a single country.
Nevertheless, many fund analysts say the increasing trend toward globalization might be reducing the need for outsized foreign allocations. Lipper strategist Andrew Clark says that the world's major economies -- the U.S., Japan and Europe -- are growing more and more synchronized, thus reducing the need for U.S. investors to cross borders.
Ronald Roge, financial adviser at New York-based R.W. Roge & Company, agrees, saying, "Due to globalization, foreign funds provide less diversification than they did 10 years ago." Nevertheless, Roge has increased his position in his favorite foreign funds, the
Julius Baer International Equity fund and the
First Eagle Overseas fund, as "a play against the dollar." Most funds do not hedge currency risk, so a declining dollar tends to boost foreign stocks.
Analysts say emerging markets funds remain relatively uncorrelated to the global marketplace, which is why many suggest a two-fund strategy of combining a foreign large-cap value fund with an emerging-markets fund or a single-country exchange traded fund to provide some extra kick. Single-country ETFs, which are index funds that trade like stocks, are now available for countries across the globe, including the
iShares MSCI Brazil Index
iShares MSCI Japan Index
ETF and the recently released
iShares China Trust
Clark, however, warns investors interested in pursuing this two-pronged approach to rebalance their portfolios quarterly, as emerging-markets funds tend to be volatile. He also suggests checking the large-cap fund for the presence of emerging-markets-based companies to avoid overlap, which can be a drag on performance. The typical country or regional breakdown in international large-cap value funds is 63% Europe, 20% Japan, 10% Asia ex-Japan, 4% Canada and 2% Latin America.
Aside from the risk doubling up on emerging markets stocks, investors also need to be cognizant of overlap with regard to their domestic portfolios. A large number of domestic funds have up to 10% of their holdings in international names such as English drug giant
or Japanese carmaker
"Investors need to keep in mind how their international funds interact with their domestic funds to avoid doubling up," says Morningstar's Rocco.
One way to avoid overlap is to think about sector diversification in your overall asset allocation. That means checking to see how your current portfolio is weighted in terms of sectors before adding a foreign fund. For example, if your portfolio is already loaded up with domestic pharmaceutical stocks, then there is no reason to add a fund teeming with European or Israeli drug companies just because they are based overseas.
Finally, Gary Schatsky, financial adviser with Objectiveadvice.com, says that foreign companies might make some high-quality products -- but that fastidiousness doesn't always translate into better transparency. So beware of possible balance-sheet issues at some of the lesser-known companies overseas, where bookkeeping rules can be less stringent.
"As bad as transparency and accounting problems are over here, its worse in Europe," says Schatsky. "But you still have to be exposed to foreign stocks. No doubt about it."