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Course 305
Choosing an International Fund, Part 1


By April 2011, U.S. investors had poured $1.4 trillion into funds that primarily buy stocks of foreign companies, according to Morningstar Fund Flow Data.

What's the attraction? Alluring returns, for one. Over the trailing 10 years through the first quarter of 2011, international stock funds have returned 7.45% per year on average, versus 5% for domestic stock funds, and only 3.3% for the S&P 500. What's more, foreign investing offers sought-after diversification. As we discussed in Lesson 301: Why Diversify?, if you own a variety of investments, chances are you'll always have a hand in something that's performing well.

Unless you understand how to evaluate these funds, though, investing abroad can be pretty harrowing. The key to smart foreign-fund investing comes down to looking beyond returns and Morningstar ratings and understanding how your fund invests. By doing so, you will be able to set reasonable expectations for the investment and uncover its hidden risks—and avoid surprises. Start by asking the following two questions. You can find most of the answers to these questions on the Morningstar Fund Report, on the fund family's Web site, or in the fund's shareholder report.

Does the Fund Own Emerging-Markets Stocks?

A good portion of the outperformance of international stocks over the trailing 10 years is due to emerging-markets equities, or stocks of companies domiciled in smaller or less developed markets, such as India, China, or Russia.

Owning emerging-markets stocks has its benefits. First, they can generate robust returns: Over the last 10 years through the first quarter of 2011, diversified emerging-markets funds have blown just about every other fund category out of the water, with an annualized 16% return. Emerging-markets stocks also add more diversity to a U.S. portfolio than stocks from many of the more-developed international markets, such as Germany and the United Kingdom, do. That's because the returns of the U.S. market and other developed markets tend to move in tandem.

There's a price for emerging-markets stocks' exhilarating highs and diversification, though: the threat of steep losses. In June 1998, for example, the MSCI Emerging Markets Index was in a free fall: It had shed 19% in the preceding six months. The developing world suffered currency collapses and soaring inflation, and investors' returns suffered. Then, during the financial crisis of 2008, emerging-markets funds swooned again, dropping over 50% on average, far worse than the S&P 500's 37% drop for the year. If oscillating fortunes make you sweat, limit your search to funds that are light on emerging-markets stocks.

If you're trying to avoid emerging markets, you'll need to be vigilant; after all, most diversified international funds nibble at emerging-markets stocks. In fact, the average fund in the foreign large-blend category held more than 11% of its assets in emerging-markets names in April 2011. Your best bet is to find out which countries a fund frequents. Funds that go shopping in Europe, the U.S., and Japan are focusing on developed markets. But if you see a number of companies from countries in Latin America or the Pacific Region, you'll know that the fund is venturing into emerging markets.

Does It Concentrate in a Specific Region or Country?

While you are examining a fund's country exposure, get a feel for whether the fund prefers a few markets or a particular region, or whether it casts a wider net. Morningstar clumps international funds that focus on a single region into one of the following regional categories: Europe stock, Latin America stock, Japan stock, Pacific/Asia stock, China region stock, and Pacific/Asia ex-Japan stock.

However, funds can overweight particular countries or regions and still land in the broad foreign-stock category because they have enough variety among their holdings to avoid being classified as regional funds. For example, Oakmark International OAKIX and Columbia International Value housed 25% and 30% of their assets in Japan, respectively, in early 2011. The average foreign large-blend stock fund, by comparison, holds 18% in Japan.

Note that a good dose of any single region or country (especially volatile Japan) can deliver uneven results. Largely due to its hefty Japan stake, Columbia International Value has returned far less than most of its peers following the financial crisis of 2008. If you are looking for a smoother ride, find funds that own stocks from a wide variety of markets.

Quiz 305
There is only one correct answer to each question.

1 Why own an international fund?
a. For the often good returns.
b. For the diversification.
c. Both.
2 To choose a good international fund:
a. Rely solely on Morningstar ratings.
b. Look only at past returns.
c. Understand how the fund invests.
3 Which of the following is not true about emerging-markets stocks?
a. They are low risk.
b. They can offer stunning returns.
c. They offer diversification.
4 To find out if a fund owns a lot of emerging-markets stocks:
a. Find out what its Morningstar category is.
b. Examine what countries most of its stocks hail from.
c. Look at its star rating.
5 Which would likely be most volatile?
a. A diversified foreign-stock fund with 10% of its assets in emerging-markets stocks.
b. A diversified emerging-markets fund.
c. A Latin America fund.
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