Dear Dagen: Do I Really Need International Funds in My Portfolio?

While it seems that world markets move together these days, over longer periods that's not the case.
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I continually hear that as part of my mutual fund allocation, I should have funds with exposure to foreign markets. Yet I often see that the foreign markets react to the U.S. market. We're up; they're up. We're down; they're down. In addition, foreign-oriented funds generally have higher operating expenses. Wouldn't I be better off to have a fund that invests in companies that the manager thinks have the best potential for future gain, whether American or foreign? -- Marv Gutwein

Marv,

On any given day, you might hear that the overseas markets have fallen overnight because of a bad day in the States.

What you are observing is a short-term correlation between these markets. In short periods, these markets might move together, most clearly when there is a shock like the U.S. market rising or falling dramatically, says Jeff Bahrenburg, global investment strategist at

Merrill Lynch

. "You have periods such as the collapse in 1987 when correlations are higher," he says. But "over time, there is a major divergence."

For instance, Japan's

Nikkei

index is trading at about 50% below its high reached around the end of the 1980s, while the

Dow Jones Industrial Average

has climbed about 288% over the same period.

You also can look at a foreign index's rolling five-year returns as loose evidence that the U.S. and foreign markets can diverge significantly. For five five-year rolling periods that ended December 1986 through December 1990, the returns of the

Morgan Stanley Capital International's Europe, Australasia and Far East

index, the EAFE index for short, noticeably outperformed the

S&P 500

, according to data from

Ibbotson Associates

. And so, too, the reverse can happen.

But that brings me to the heart of your question. Should you be in international at all? Many financial professionals will argue that you need the diversification of other asset classes, like international stocks, to dilute risk and increase your returns. "You absolutely have to have exposure to foreign markets," insists Ben Tobias of

Tobias Financial Advisors

in Plantation, Fla. Very often you will hear that anywhere from 5% to 30% of your equity allocation should be in international stocks.

Just a few days ago, a story in

The Wall Street Journal

quoted some numbers from

T. Rowe Price

in a convincing argument for diversification. If you compare the

Wilshire 5000

index and the EAFE index, they have both returned an annualized 13.7% from the end of 1970 through the end of 1998. But if you had constructed a portfolio of 70% Wilshire index and 30% EAFE index and rebalanced these allocations every year, your annual return would have been a bit better -- 14%, before taxes of course.

But you can find some famed professionals, namely

Vanguard Group

founder

John Bogle

, who aren't so convinced by the overseas argument. "Overseas investments -- holdings in the corporations of other nations -- are not essential, nor even necessary, to a well-diversified portfolio," writes Bogle in his new book,

Common Sense on Mutual Funds

. "For investors who disagree -- and there are some valid reasons for global investing -- I would recommend limiting international investments to a maximum of 20% of a global equity portfolio."

If you do decide to allocate a portion of your portfolio to international investments, you will probably be better off using a pure international fund instead of a global fund, which will invest in both domestic and foreign stocks. With a global fund, you are leaving the foreign allocation up to the fund manager; therefore the international component of your portfolio is virtually out of your hands. With a pure international fund, you have complete control over how much of your money is in international stocks.

"The point is you can't be wishy-washy," says David Foster, a financial planner with

Foster & Motley

in Cincinnati. Decide here and now if you want a portion of your money overseas. "It is either do it or don't do it."

True, the expense ratios on foreign funds will likely be higher. But here you need to compare relatively similar funds to see which one is going to charge reasonable fees, says Jay Shein of

Compass Financial Group

in Lighthouse Point, Fla. And despite Bogle's caution on international investing, you will be able to find low-cost international funds at Vanguard.

For more on international investing, you can read

my column from last month.

Send your questions and comments, along with your full name, to

deardagen@thestreet.com.

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