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U.S. Funds Go International

Growth Fund of America and other funds are finding better values or faster-growing companies abroad.

For years, American Funds' Growth Fund of America (AGTHX) remained true to its name.

With nearly all its assets in U.S. growth stocks, the fund compiled a successful track record and came to rank as the biggest mutual fund, with $179 billion in assets. But, lately, Growth Fund of America has veered from its traditional path. Now, 20% of assets are in foreign holdings, including German software powerhouse SAP (SAP) and Swiss pharmaceutical company Roche (ROG.VX).

American Funds is hardly alone. Many domestic funds hold big stakes abroad. Top performers with more than 20% of assets in foreign stocks include GM Focus (CGMFX), Fidelity Contrafund (FCNTX) and Royce Low-Priced Stock (RYLPX). "The distinction between foreign and domestic funds is becoming less clear," says Greg Wolper, senior fund analyst for Morningstar.

Fund managers say they have been looking abroad in search of bargains or fast-growing companies. Until the recent market downturn, many foreign bets paid off handsomely, the managers note. During the five years ending in 2007, the Morgan Stanley Capital International EAFE index returned 21.6% annually, outdoing the S&P 500 by more than 8 percentage points. But this year, the tables have turned. For the first seven months of 2008, the S&P 500 outpaced the Morgan Stanley international index by more than a percentage point.

Now that foreign stocks are dragging down results, shareholders may question the wisdom of domestic portfolio managers who shop abroad. Some financial advisers go further, viewing the shift to foreign stocks as an undisciplined strategy. These advisers prefer funds that stay pure, focusing on one style, such as domestic small growth or foreign large value. With pure funds, an investor can control a portfolio's allocations to foreign and domestic stocks.

Should you worry if one of your funds shifts a small percentage of assets to foreign stocks? Not necessarily, says John Sterba, president of Investment Management Advisors in New York. "If you have picked a great manager, then you should allow him some freedom to search for the best stocks," he says.

The impact of foreign holdings on a portfolio is not always pronounced, Sterba says. In the past, it was clear whether a company was domestic or foreign, but now the lines blurred. ExxonMobil (XOM), the largest member of the S&P 500, obtains 70% of its revenue abroad. UK-based BP (BP), the oil giant that is the biggest stock in the Morgan Stanley international index, has the same breakdown, with 30% of revenue derived from the U.S.

Still, investors should not ignore foreign allocations altogether. As recent market performance demonstrated, foreign and domestic markets do not move in lockstep. Many stocks remain tied to their local markets. For example, the success of French real estate companies depends mainly on the health of the home country, not the rises and falls of Wall Street. So by holding a mix of foreign and domestic stocks, you can achieve diversification and perhaps cushion downturns.

To keep some control of allocations, put most of your holdings in funds that are purely domestic or international. Then consider investing a small percentage of the portfolio in one or two strong funds that roam freely. Such flexible funds could deliver extra returns and perhaps protect your portfolio during declines.

A top flexible choice is Pioneer Cullen Value (VFCX), which has returned 11.7% annually during the past five years, outdoing 97% of large value funds, according to Morningstar. Pioneer Cullen currently has about 25% of its portfolio in foreign stocks. "By considering foreign stocks, you increase the number of great companies that are available to buy," says portfolio manager Jim Cullen.

A diehard value investor, Cullen focuses on stocks with price-to-earnings multiples in the bottom 20% of the market. The aim is to buy out-of-favor companies that seem poised to deliver earnings growth. Holdings include Swiss-based Nestle (NESN.VX) and GlaxoSmithKline (GSK), the U.K. pharmaceutical giant.

Another bargain hunter is Columbia Value & Restructuring (UMBIX), which has returned 13.5% annually during the past five years, besting 99% of large value competitors. The fund currently has 18% of assets abroad. Portfolio manager David Williams looks for troubled companies that seem likely to turn around because of new managements or shifts in strategy. "I buy stocks when they are hurting, and I like to hold them for a long time," he says.

Columbia buys foreign stocks when they seem very cheap compared to U.S. counterparts. A holding is ACE Limited (ACE), a Swiss insurer. By shopping abroad, Williams aims to stay a step ahead of competitors who only invest at home.