Making Wise Foreign Fund Decisions

That's hooey. For one thing, the increased correlations are partly an artifact of the rise and demise of the global market bubble of the past five years. The technology, telecommunications, and media sectors ballooned and shrunk in sync, thereby adding near-term credence to the "one-world" thesis. Those sectors are significantly smaller now in terms of market capitalization, and I strongly suspect that nominal correlations will shrink.

Growth Opportunities
More fundamentally, many of the global economy's most exciting growth opportunities lie outside the United States. That's especially true of the burgeoning markets in China, Southeast Asia, and the periphery of Europe. For the first time in years, Japan has ignited some interest among fund managers who have been longtime bears on that market. They argue that change is happening from the bottom up--many firms are increasingly running their businesses with an enhanced focus on profitability, even though the political and macroeconomic climates are still uncertain. The growth prospects for continental Western Europe, on the other hand, continue to be dim.

Meanwhile, the U.S. remains the world's most dominant economy, but soaring budget and trade deficits are a source of concern for many observers. The dollar's decline over the past year has been a central proxy for that concern. Nor is the U.S. stock market particularly cheap on a historical basis or relative to other countries. In brief, other markets might offer more growth for cheaper valuations.
 
As we approach the end of 2003, it's fair to say that investors who ventured abroad recently have been rewarded this year. With Morningstar's new foreign-stock investment categories, it's now easy to see that in every corner of the equity markets--large and small cap, growth and value--foreign investments trumped domestic. The differences aren't night and day, but they are noticeable. Equity markets are quite efficient, and these outperformances mean, to some extent, that investors have been showing a preference for the more attractive risk/reward profiles of international stocks.

Sensible Foreign Investing
My fear, however, is that some hot foreign funds (especially small caps) will induce investors to simply chase performance and somewhat arbitrarily pick one fund over another based on short-term gains.

But that's not a sensible way to build international exposure over the long haul. Especially if international markets offer outsized opportunities over the next few years, investors should formulate a well-designed plan to take advantage of them. Here are some tips.

• Buy more than one fund. The days of buying just one "international" fund for your overseas exposure are over. Investment style matters as much in foreign markets as it does in the United States. Like with your U.S. holdings, it makes sense to assemble at least a couple if not more funds that provide access to different sorts of stocks. Morningstar has broken out of the broad foreign stock category into five finer-grained categories to help you make those decisions more easily. One idea is to pair a conservative foreign large-value fund with a racy foreign small/mid-growth vehicle. Or pick a foreign large-blend fund and add one or two small- or mid-cap funds for some zip. There are numerous possibilities.
   
• Be aware of global portfolio overlap. You must consider your domestic funds when managing your international exposure. Correlations should be lower than they've been in recent years, but pairing a U.S. large-growth fund with a foreign large-growth fund is less than optimal. (In fact, they might have 5% to 10% stock overlap.) Take a holistic view to your investments and realize the full benefits of diversification, both by country and by style. Using Morningstar's  X-Ray Overview tool (a Premium benefit of Portfolio Manager) is a great way to get the straight dope on your holdings.
   
• Know the risks. Different companies feature different risk/reward profiles. Small caps might offer better long-term growth than mega-caps, but the latter provide more stable businesses. Understand and be comfortable with the risks you have in your portfolio. Arguably, the most exciting area to buy now is emerging markets. The average fund in that category is up 44% this year, testifying to some sizzling growth opportunities. But such investments can be quite volatile--they often swoon after they soar.
   
• Dollar cost average. There are tactical issues of how to buy, aside from what to buy. The best time to buy a security is when it bottoms right before it spikes. The problem is that neither you nor I (nor just about anybody) can consistently pull off that high-wire act. So once you've picked your lineup, ease into each selection over time. It'll be hard to resist adding extra to that fund with sexy year-to-date numbers, but resist nonetheless. If anything, add a bit extra to the high-quality funds you've picked that are not topping the performance charts this year.
   
• Consider cost matters. Foreign funds generally cost too much. Fund companies justify the costs by pointing to the added research necessary for knowing harder-to-follow stocks. Especially for large-cap funds, that's baloney. Fight back by taking a few extra minutes to find the well-managed, successful foreign fund that also costs less than its peers. Low expenses are a good predictor of future relative performance. That insight applies to all funds, including international offerings. So adhere to it.