For the past few years, it's been hard to go wrong investing overseas, as mutual funds and exchange-traded funds that hold foreign stocks have consistently outperformed their domestic counterparts. That's likely to be the case again this year, but given the uncertainty about U.S. interest rate outlook, we believe the prudent investor may want to move some money out of volatile emerging markets and into Europe.

The average top-rated international stock mutual fund (B-minus and above) returned 26.7% in 2006 and has risen an annualized 20.18% for the three years ended Dec. 31, compared with the top-rated domestic stock funds, which returned 19.11% on average last year, and an annualized 14.75% over the past three years.

The story is much the same for ETFs, which resemble index-oriented mutual funds but trade throughout the day on an exchange, like stocks. Our top-rated international stock ETFs returned 35.5% in 2006, compared with 19.59% for domestic stock ETFs, and have returned an annualized 13.27% over the past three years, compared with 5.5% for domestic stock ETFs.

In the ETF universe, at least, funds that invest in emerging markets were among the biggest winners. iShares FTSE/Xinhua China 25 ( FXI ) led the pack with a return of 82.98%, followed by iShares MSCI Spain ( EWP), up 49.25%, and iShares MSCI Singapore ( EWS), up 45.68%.

Among mutual funds, managers who spread their bets around the world came up on top, although their holdings of emerging-market stocks undoubtedly helped them. In first place was ( GFSFX) GMO Foreign Small Companies IV, up 35.89%, followed by ( OAREX) Oakmark International Small Cap II, up 34.72%, and DFA International Value IV, up 34.4%.

But while emerging markets outperformed European markets last year, on average, they may be in line for a correction. In fact, the Chinese government recently stopped allowing new domestic equity funds to launch, out of concern over the country's stock market overheating.

According to China's National Development and Reform Commission, the country's economy grew 10.5% in 2006 -- the fourth consecutive year of double-digit growth. And just last month, Yao Jingyuan, chief economist at China's National Bureau of Statistics, told a conference that a key objective for economic planners in 2007 is to make sure the economy doesn't overheat from rapid growth and investment.

Even though many emerging markets have very good fundamentals, such as solid economic growth and low inflation, which should spur further gains there, they are also vulnerable to investor sentiment. For example, in May and June of 2006 there was what we feel was an irrational hiccup in the emerging markets when the mere threat of interest rate increases in the U.S. led to an average 30% drop in these markets. And it was guilt by association for any emerging-market investment, as investors didn't discriminate one from another.

Once the fear of rate rises dissipated, these markets recovered, but last summer's selloff could foreshadow what will happen if there is more speculation of interest rate movements. In our view, because the U.S. is such a major investor in emerging markets, if U.S. rates move up in 2007--thus holding some investors back--those markets will be hit again.

European markets aren't as vulnerable to concerns about interest rates, and for this reason alone, we believe moving money out of emerging markets and into Europe would reduce risk.

Fund Name Ticker 1 Year 3 Year 5 Year TheStreet.com Rating
iShares MSCI Spain EWP 49.25 25.78 22.03 A+
iShares S&P Europe 350 IEV 32.56 19.78 13.95 A+
iShares MSCI Austria EWO 36.76 41.12 39.26 A+
iShares MSCI EMU EZU 35.49 20.87 14.36 A+
iShares MSCI France EWQ 33.54 20.2 13.82 A+
iShares MSCI Sweden EWD 43.71 28.86 18.66 A+
iShares MSCI Germany EWG 34.95 19.48 13.06 A+
Source: TheStreet.com Ratings

Fund Name Ticker 1 Year 3 Year 5 Year TheStreet.com Rating
iShares FTSE/Xinhua China 25 FXI 82.98 N/A N/A A+
iShares MSCI Singapore EWS 45.68 26.19 19.18 A+
iShares MSCI Pacific ex-Japan EPP 32.35 23.78 21.19 A
iShares MSCI Mexico EWW 44.8 46.04 28.68 A-
Vanguard Emerging Markets ETF VWO 29.33 N/A N/A B+
iShares MSCI Malaysia EWM 36.3 15.74 14.86 B+
iShares S&P Latin American 40 ILF 40.99 43.76 30.07 B+
Source: TheStreet.com Ratings

Sam Patel, CFA, is the manager of mutual fund research for the TheStreet.com Ratings.

In keeping with TSC's Investment Policy, employees of TheStreet.com 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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