Keep Shopping Overseas

With the stock market wobbling, many investors are paying more attention to fixed-income investments and reducing international equity exposure.

But it's an excellent time to add international holdings -- provided you understand the risks and content of what you're buying.

Human resources and consulting firm Hewitt Associates reports that 401(k) investors poured about $3.2 billion into international and emerging market equity funds between January 2003 and April 2006. At the end of April, the typical 401(k) account had about 7.93% of its assets in international equity.

However, 401(k) investors began reducing their international exposure in May as the stock market swooned. At the end of June, the typical 401(k) account had only 6.77% invested in international funds and another 0.74% invested in emerging markets -- a decline in total equity exposure to 7.51%, according to Hewitt. During June alone, more than a quarter of a billion dollars of 401(k) money moved out of international and emerging market equity funds -- and most of the net transfers were fixed-income bound.

Investors are right to be cautious about emerging market funds, which have been producing red-hot returns that aren't sustainable. But investors looking for a "safe harbor" and exiting from international funds of all kinds are cutting themselves off from good investment opportunities. And the exodus out of these funds is creating a buying opportunity.

Emerging Concerns

First, let's take a look at two emerging market index funds. As of mid-July, the ( VEIEX) Vanguard Emerging Market Stock Index fund is up 6% year to date and 29% over the past 12 months, according to Morningstar. The iShares MSCI Emerging Market Index ( EEM) exchange-traded fund is up 4.5% for the year to date and 25% for the past 12 months.

These funds have diversified exposure in emerging markets, typically with somewhat higher concentrations in South Korea (18% to 20%), Taiwan (11.2% to 16.6%), South Africa (11.5% to 13.2%), Brazil (8% to 11%) and Hong Kong (8% to 10%).

Emerging markets investments have been on a tear for the past three years -- Vanguard's emerging markets index, for example, produced a three-year annualized return of over 32% -- and that kind of performance simply is not sustainable. And, indeed, many emerging market, China and Latin American-focused funds have begun to correct.

But current pricing is inflated. Emerging market investments should be long-term holdings in every portfolio, but wait until the speculative froth blows off. If you go in now, you'll be "buying high" and setting yourself up for a downdraft.

Foreign Flair

There are, moreover, other international indices with no, or only limited, emerging market exposure.

International Appeal
Symbol Fund or ETF P/E Dividend Yield Performance (as of July 13)
YTD 12-months
EFV iShares MSCI EAFE Value Index n/a n/a 9.32% n/a
EFA iShares MSCI EAFE Index n/a n/a 8.28% 22.33%
VDMIX Vanguard Developed Markets Index 15.1 2.7 8.62% 22.71%
FSIIX Fidelity Spartan International Index 15 3 8.59% 22.77%
VGTSX Vanguard Total International Stock Index 14.4 2.8 8.20% 23.48%
SWINX Schwab International Stock Index 14.6 2.9 8.88% 21.53%
Source: Morningstar

Compared to emerging market indices, these particular index and exchange-traded funds have slightly varying amounts of exposure in the stocks of Japan (22% to 25%), the U.K. (20% to 24%), France (8% to 10%), Switzerland (6% to 7.5%) and Germany (6% to 7.6%). Only two -- Vanguard's ( VGTSX) Total International Stock Index (which I hold) and Schwab's ( SWINX) International Index -- have small amounts of emerging market content. All of the others are focused on developed markets, albeit with rather small allocations to Singapore and Hong Kong.

I believe that long-term investors will benefit by keeping at least 25% of their equity exposure in international stocks -- substantially more than the 7% currently in 401(k) plans. And using broad index funds like these is an excellent way of achieving international diversification.

International stocks and funds give investors exposure to markets that represent more than 50% of all stock opportunities in the world. That means that investors more than double their access to potentially exciting equity investments when they look at non-U.S., in addition to U.S., equity opportunities. Enlarging international exposure can provide more opportunity for growth, as well as give stronger diversification.

I'm also a proponent of international investments because of demographics. Over the next two decades, the U.S. population will age and consumer spending of many kinds will slow. By comparison, countries like India and Brazil will have great numbers of people moving into their peak consumer and investment years over the same time frame.

The price-to-earnings ratios for international stocks are attractive, and the concern about the migration from stocks to bonds is creating buying opportunities. If you can ride out periodic volatility, it's worth it to stay the course.

Using broad index funds, like the ones I listed above, are an excellent way of achieving international diversification. There also are a number of actively managed international funds that are attractive. I particularly like the ( ARTKX) Artisan International Value fund, the ( DODFX) Dodge & Cox International fund, the ( ICEUX) ICAP International fund and the ( SILAX) Wells Fargo Advantage International fund.

If you have moved out of an emerging market position because of the speculative buildup, good for you. But don't discount this important equity category over the long term. When prices simmer down, you will most certainly want emerging market exposure in your portfolio.

In the meantime, take a close look at actively managed as well as index international funds that are not top-heavy in emerging markets. As 401(k) investors look for refuge in fixed income, this could be a good time to buy international positions for the long term.

Jim Schlagheck is a wealth management professional who has counseled ultra-high-net-worth families, endowments and pension funds in the U.S., Europe, and the Middle East. He is a former senior executive of American Express Bank, UBS AG, Bank Julius Baer, and TAIB Bank. During his career, Schlagheck launched a family of mutual funds (now holding $4 billion), led teams of financial planners and investment advisers based in New York, Bahrain, and Geneva, Switzerland, and helped many high-profile clients to protect and enlarge their wealth. Jim has a blog on investment topics www.invest-blog.com and is the author of "Show Me The Money!", a soon-to-be-published book that synthesizes his novel views about investing for retirement.

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