These days it takes a lot of courage for mutual-fund investors to venture overseas. On the face of things, it sure doesn’t seem like an opportune time.
And picking international funds is a bit trickier than finding high-potential U.S. funds. Investors should look for many of the same things they seek in choosing funds investing in U.S. stocks. But with international funds, there are also “a couple of twists to consider,” says Tricia Oehme Rothschild, international-funds editor at Morningstar Inc., Chicago.
So, for those willing to take the risk, here’s a guide to picking promising international stock funds.
– Track record. As with U.S.-stock funds, ideal are international funds with long-term managers who have turned in robust returns for five or more years without taking excessive risks. Make sure, however, that a fund’s strong returns aren’t the reflection of a single terrific year. Also be sure that the people responsible for that impressive track record still run the fund. You can find out in the fund’s prospectus (and sometimes the annual and semiannual reports), or by asking the fund company.
– Benchmarks. Because international markets don’t move in sync with the U.S., measure a fund’s performance against appropriate benchmarks like an international index (such as Morgan Stanley’s EAFE index of Europe, Australia and the Far East).
Another benchmark: “It’s probably better to compare international managers to each other” rather than a broad international index, says Susan Belden, editor of No-Load Fund Analyst in Orinda, Calif. That’s because the huge Japanese market, which has been a dog for years now, has a big representation in broad indexes but not in the portfolios of most international funds. A mediocre international fund might look good compared with an index simply by staying out of Japan.
– Expenses. Of course, a stellar fund manager in one period won’t always look as impressive in the next. To improve your odds of strong performance, look for a fund with low expenses, because the cost of running a fund is taken out of the returns earned by an investor.
Typically, international funds have higher expenses than domestic-stock funds. Broadly diversified international-stock funds have an “expense” ratio–the annual expense of running the fund as a percentage of assets–of 1.66 percent on average, according to Lipper Analytical Services Inc. In comparison, expenses of growth-and-income funds, which principally invest in the U.S., are 1.27 percent on average.
– Currency. One twist to international-stock funds that you don’t have to worry about in picking a domestic-stock fund is how the fund handles currency risk.
Imagine, for the sake of simplicity, that a fund owns one and only one stock, a Japanese company. You buy the fund with U.S. dollars, which get changed to Japanese yen to buy the stock. The next day, the stock price is unchanged, but the value of the yen declines 5 percent against the dollar. When translated from yen back into dollars, the value of your investment has also declined 5 percent–even though the stock price didn’t change.
Some funds hedge currencies, reducing the impact on returns from foreign-currency movements. Other fund managers argue that hedging currencies is expensive and difficult to do well, because currency movements are hard to predict. Analysts say they see virtues to both approaches, but investors should know what their fund’s approach is so they can better understand the fund’s returns. For instance, last year funds that hedge had an edge over funds that don’t, because the dollar rose against foreign currencies. At other times, when the dollar declines, unhedged funds tend to do better.
Unfortunately, it can be hard to get a handle on a manager’s policies toward currency hedging. Disclosing the role of currencies in international-fund returns is “something people should be pushing for,” says Morningstar’s Rothschild. “Funds should be disclosing more.”
Many funds don’t disclose what portion of their return comes from market action, and what portion comes from currency gyrations. As for general policy, disclosure documents such as prospectuses often give only a very general policy.
You can look at the portfolio in the annual and semiannual reports and see if the fund has 10 percent or more of the portfolio invested in currencies, says Rothschild. She notes that the word “hedging” may be misleading: “Hedging sounds like it’s safe, but it really means shifting the risk to a different currency.”
– Country weighting. Another issue that rarely affects U.S. stock funds but that can have a big influence on foreign-stock funds is “country allocation.” A fund that picked only the best stocks in Thailand last year would turn in a weaker performance than one that picked only mediocre stocks in Europe. Fortunately, getting a picture of a fund’s country allocation is pretty easy. The percentages in each country will be listed in a fund’s annual and semiannual reports, and some fund companies will give a more up-to-date accounting over the phone.
Often, analysts suggest investing in purely international funds, which invest only overseas, rather than “global” funds that invest in the U.S. and overseas. For the same-size investment, your expenses would be less investing in both a lower-cost U.S. fund and an international fund, rather than in a higher-expense global fund investing in the same portfolio of stocks.
– Abroad or at home? Left aside in most discussions about picking international funds: Why should you invest there at all? Only a few years ago, investment analysts at firms such as Ibbotson Associates of Chicago trumpeted the benefits of investing in foreign stocks. They argued that in every five-year period on record, foreign stock markets in aggregate outperformed U.S. stocks. That’s no longer true. For the five years through the end of October, for instance, the Morgan Stanley EAFE index of major foreign markets had a total return of 74.27 percent, just about half the 147 percent return of Standard & Poor’s 500-stock index.
“People have to be careful how they think about international” stock investments, says Derek Sasveld, a senior consultant at Ibbotson. He expects only marginal, if any, extra returns in the future from international stocks. And while diversification may help investors over periods of several months or years, during which international stocks could do better than U.S. stocks, spreading the risk doesn’t help in short, sharp market declines, which in recent years have tended to pull down all markets. Bonds or bond funds, he says, do better in a quick crash. Ibbotson recommends putting as much as 30 percent of a stock portfolio overseas–even 35 percent for the truly adventurous.
Many advisers have cut clients’ exposure overseas far below those levels. But there are still strong reasons to invest overseas, say true (if battered) believers. “There are just some great companies” overseas, says Sheldon Jacobs of No-Load Fund Investor of Irvington, N.Y.
