For the past three years or more, it has paid to invest overseas, and October was no exception. The table below shows that mutual funds with an international focus (including global funds that have some U.S. exposure) outperformed their domestic counterparts in the first 10 months of the year as well as for the year and the three years ended Oct. 31.

But domestic funds are starting to close the gap, thanks largely to a record-breaking run in the Dow Jones Industrial Average. As the table shows, the returns of domestic funds don't lag foreign funds by nearly as much for the past three and six months.

There are plenty of reasons to think foreign funds will continue to outperform. The markets where these funds invest are marked by robust economic growth, low inflation and low unemployment.

Looking at it another way, the U.S. current-account deficit is at record levels, which implies that the U.S. is importing goods in record quantities. These goods are being made, and the money is being earned, in the markets where foreign funds invest.

Investors should keep in mind that international funds will benefit from any devaluation of the U.S. dollar that may occur in 2007 and onwards. However, the direction of the U.S. dollar is very difficult to predict, and this currency aspect of international funds is noted only as a potential additional benefit to international investing in the current economic climate.

For investors considering whether to put money overseas, it may be helpful to take a closer look at performance of different kinds of foreign and domestic funds over both the short term and long term.

The Ratings looks at a universe of some 10,600 stock mutual funds and separates this universe into 21 separate categories or sectors. In each category, we will only look at only the top 20 rated funds as determined by our models. This will focus our attention on the most profitable funds in each category, and because we are displaying average returns, remove any bias that would occur given that some categories have more funds in them than others.

So these averages are calculated using the same number of funds in each category, and only the best-rated funds to make the comparisons as even as possible.

The second table below shows that, despite a slowing housing market, real estate is the only category of funds besides non-U.S. equity that has remained in the top five for the year-to-date, one year and three years ended Oct. 31. Although softer home prices and lower home sales have hit stocks of homebuilders and mortgage lenders, many real estate funds are benefiting from large holdings of real estate investment trusts. Some of the best performers also invest in properties in the U.K. and Europe.

Our top-rated real estate funds that are still open for new investment and require a minimum initial investment of $5,000 or less are JPMorgan U.S. Real Estate C ( JPRCX) (which we rate A) and Old Mutual Heitman REIT Fund ( OBRAX) (also rated A). The top holdings of both funds include Simon Property Group ( SPG) and Equity Residential ( EQR).

For the year-to-date, the other top performers include precious metals, utilities and small-cap funds.

Closing The Gap
Foreign funds still lead, but domestic funds are catching up
Domestic v. International Funds 3 Month 6 Month YTD 1 Year 3 Year
International Focus 3.24 1.57 11.54 16.96 20.58
Domestic Focus 2.51 -0.54 5.44 7.66 12.00
All Rated Stock Funds 2.64 -0.16 6.54 9.33 13.55
Source: Thompson Financial

Non-U.S. equity funds, which invest only in markets outside the U.S., are the only international category to make the top five categories for the year-to-date. Global equity funds, which invest both in the U.S. and abroad, and emerging-market funds are just outside but still showing competitive returns.

Foreign Funds on Top
Funds with international focus have been near the top for awhile
Category YTD % Category 1 Year % Category 3 Year %
Real Estate 22.46 Precious Metals 36.83 Energy/Natural Res 31.87
Precious Metals 19.14 Real Estate 26.48 Emerging Market Equity 30.04
Non-US Equity 18.16 Non-US Equity 23.30 Real Estate 27.32
Utilities 16.66 Financial Services 20.25 Non-US Equity 26.65
Small Cap 16.66 Emerging Market Equity 20.17 Utilities 25.84
Global Equity 13.81 Global Equity 17.38 Small Cap 25.84
Equity Income 13.58 Equity Income 15.15 Precious Metals 24.68
Emerging Market Equity 12.54 Growth & Income 14.48 Mid Cap 19.91
Growth & Income 12.43 Tech/Communications 14.47 Global Equity 19.76
Growth - Domestic 12.34 Growth - Domestic 13.54 Tech/Communications 18.49
Financial Services 11.48 Utilities 12.88 Growth - Domestic 18.29
Tech/Communications 10.93 Small Cap 12.88 Financial Services 18.12
Mid Cap 9.73 Asset Allocation - Domestic 12.25 Health/Biotechnology 17.52
Asset Allocation - Global 9.72 Asset Allocation - Global 12.23 Equity Income 17.35
Asset Allocation - Domestic 9.55 Mid Cap 11.99 Growth & Income 16.47
Balanced - Domestic 9.18 Aggressive Growth 11.95 Asset Allocation - Domestic 16.32
Aggressive Growth 9.00 S&P 500 Index 10.64 Aggressive Growth 15.49
S&P 500 Index 8.43 Balanced - Domestic 10.22 Asset Allocation - Global 15.37
Energy/Natural Res 6.98 Convertible 7.98 Balanced - Domestic 13.02
Convertible 6.94 Health/Biotechnology 7.41 S&P 500 Index 12.09
Source: Thompson Financial

Now let's look at the three and six months ending Oct. 31. The Dow's rally has pushed all three international categories out of the top five rankings and, despite a mass of commentary about the fragile state of the U.S. real estate market, it clearly continues to drive investment returns here.

Foreign Fund Ranks Slipping
As Dow rallies, domestic funds are knocking foreign funds from pole position
Category 3 Month % Category 6 Month %
Real Estate 8.72 Utilities 10.63
Tech/Communications 6.79 Small Cap 10.63
Growth & Income 6.36 Real Estate 7.33
Utilities 6.03 Equity Income 7.20
Small Cap 6.03 Growth & Income 7.18
Health/Biotechnology 5.83 Growth - Domestic 6.45
Financial Services 5.67 Global Equity 5.72
S&P 500 Index 5.60 Non-US Equity 5.57
Equity Income 5.44 Balanced - Domestic 4.54
Growth - Domestic 5.28 S&P 500 Index 4.03
Global Equity 5.01 Financial Services 3.53
Non-US Equity 4.76 Asset Allocation - Global 3.28
Balanced - Domestic 4.15 Tech/Communications 3.10
Asset Allocation - Domestic 4.07 Asset Allocation - Domestic 3.04
Asset Allocation - Global 3.94 Aggressive Growth 2.90
Emerging Market Equity 3.85 Mid Cap 2.81
Aggressive Growth 3.79 Convertible 1.54
Mid Cap 3.67 Emerging Market Equity 0.40
Convertible 2.69 Health/Biotechnology -0.49
Precious Metals -5.50 Energy/Natural Res -3.09
Source: Thompson Financial

The bottom line is that if you believe that the Dow is headed for some type of pullback or correction, then you may want to take some money out of the U.S. market and move it overseas.

Let's put it another way -- how much higher can the Dow go in 2007? We may need the whole of 2007 to justify its current level. If you think it's headed for 13,000 and above, then the U.S. is the place to be and real estate, tech/communications, growth and income (essentially dividend-paying stocks), utilities and small-cap are the sectors to be in, according to our research.

If you think the Dow has had its day for now and you want to go international, you should definitely consider global equity funds and non-U.S. equity funds.

Among our top-rated global equity funds that are still open and have an investment minimum of $5,000 or less is Principal Investment Divers International ( PIIJX) (which we rate A+). Its top holdings include HSBC Holdings ( HBC) and Toyota Motor ( TM).

Among non-U.S. equity funds, consider the A, B or C classes of AIM European Growth ( AEDAX) (all rated A+). It's top holdings include Anglo Irish Bank ( AGBKY) and Puma AG ( PMMFP.PK).

If you want to invest overseas and you can stomach more volatility, keep and eye on emerging markets. That's my pick for the last part of 2006 and into 2007.

Ignore the collapse in return these markets experienced in June this year, as shown by the paltry 0.40% return for the six months ended Oct. 31. Investors can read an explanation of what happened during this time and some of the risks associated with investing in such markets in my recent piece: The Ratings: A Latin American Growth Play . Also note that emerging markets funds rebounded in the third quarter, posting returns of 3.85%.

Moreover, if the Fed decides to hold interest rates steady or go lower in 2007, these markets have the potential to come roaring back.

Our top picks that are still open and have an investment minimum of $5,000 or less are the A or B classes of JPMorgan Emerging-Markets Equity ( JFAMX) (both rated B). The top holdings of both include Petroleo Brasileiro ( PBR) and Samsung Electronics ( SSNLF).

Sam Patel, CFA, is the manager of mutual fund Research for the Ratings.

In keeping with TSC's Investment Policy, employees of Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Patel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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