How far would you go for a free lunch? For many people, the answer is literally to the ends of the earth.
Believing that they can boost the returns of their portfolios while at the same time reducing their risk — thereby enjoying that proverbial free lunch — many investors have continued to pour money into foreign-stock mutual funds over the years. But as is often the case with the promise of something free, there is a problem.
Indeed, foreign funds haven’t lived up to their billing. In the summer of 1998 when the U.S. market crumbled, foreign funds fell to pieces. And in this year’s bleak market, the foreign sector, including emerging markets, has done worse than any other fund category with the exception of gold, the perpetual laggard.
While the average diversified domestic stock fund was down 1.82 percent for the year through Oct. 18, the average international fund had fallen 17.92 percent, according to Lipper Inc., Between Sept. 1 and the end of October; domestic funds were down 11.43 percent and foreign funds had fallen 14.11 percent.
Why the disappointment and what should investors do about it?
First, the obvious reasons: The U.S. economy has grown faster than that of most foreign countries and the sinking value of the euro has hurt the returns of all foreign funds with European holdings that don’t hedge their currency exposure.
But dig deeper and another problem emerges.
Most big mutual funds that invest abroad are full of big global companies — Nokia, Sony, Vodafone Airtouch and the like. These companies actually have far more in common with their global competitors from other countries, including the United States, than they do with the smaller companies from their home country.
“Those stocks are global stocks,” said Ed Rosenbaum, research director at Lipper. “You don’t own Nokia because you’re bullish on Finland.”
So it’s no surprise that funds holding these global stocks have tumbled with the U.S. market.
In fact, according to Salomon Smith Barney, the degree to which stock prices of the biggest companies in industries such as technology, natural resources, telecommunications and media move in tandem around the world has gone up significantly in the past few years.
In many cases, the movement of a stock is better explained by the performance of its industry rather than its homeland, Salomon Smith Barney found.
For example, in the first half of the 1990s, the performance of the global media industry had little connection with the movement of European media stocks, which reacted mostly to local factors.
But in more recent years, the global industry has driven about two-thirds of the movements of those European stocks.
It is possible for investors to get real diversification from their foreign mutual funds, but it just takes a little more work. A starting point is to take a look at the largest holdings of your foreign funds; if you recognize every company name, it’s a sign that your foreign funds are providing less diversification than you think compared with your U.S. funds that hold large-cap companies.
How can you increase your diversification? Look for foreign funds that focus on small and midsize companies, which tend to rise and fall with their local economies rather than with their global industry.
According to Morningstar Inc., foreign mutual funds that invest in big companies have a 68 percent correlation with funds that invest in American stocks. That means more than two-thirds of the foreign funds’ performance can be explained by movements in the American market. But buy a fund that owns small and midcap names and the correlation falls to about 50 percent, reducing the odds that the foreign and U.S. stocks will move in lockstep.
“Just investing abroad doesn’t guarantee diversification, but if you’re able to invest in a mixture of industries and maybe a mixture of sizes, then I think you will continue to have diversification,” said Leila Heckman, a managing director at Salomon Smith Barney who oversees global asset allocation.
To be sure, small and midsize companies bring added risks of their own, so the funds specializing in these stocks tend to bounce around a bit more than large-cap funds. But investors have been rewarded for taking that risk, at least recently. Over the past three years, international small-cap funds have returned an annualized 14.77 percent according to Lipper, beating the 5.92 percent return for large-cap foreign funds, and even beating U.S. diversified stock funds, which returned 11.73 percent.
One reason for this good recent performance is small stocks are becoming more popular abroad as stock investing becomes a more global pastime. The success of the Nasdaq in the U.S. has spawned small-cap markets such as the Neuer Market in Frankfurt and the Kosdaq in South Korea.
“You’ve got all the diversification arguments and you layer that with a great secular move to small companies outside the U.S. and I think it’s a great time to be investing there,” said Michael Gerding, whose 9-month-old Westcore International Frontier Fund . is up about about 3.5 percent for the year
There are two other good reasons to consider funds that invest in smaller foreign stocks. First, funds that invest in big foreign companies are forever worried about trailing their index, meaning they tend to hold the same stocks making up the index. That’s the same situation that occurs when U.S. stock funds hold big stakes in the biggest U.S. companies such as General Electric Co. and Cisco Systems Inc. because those companies represent big chunks of the S&P 500.
Small-company funds tend to be freer to buy stocks they like, rather than being pressured to track a particular index. “We don’t really care about our benchmark,” said Joseph P. Joseph, co-manager of Putnam International Voyager, which is down about 12 percent this year.
Another benefit: Smaller stock funds can buy niche players in fast-growing sectors. For example, rather than buying the big European drug companies, a fund can own the hot biotech names.
For Warburg Pincus International Small Company Fund, that has meant buying business-services companies in countries where demand is high, rather than buying big, pan-European names that are growing more slowly. “It allows us an entry into emerging growth areas that are not as easy to target through big-cap stocks,” said Federico Laffan, who co-manages the fund, which is down . about 22 percent this year.
Some other well-regarded international funds that focus on these companies include Acorn International and Pilgrim International Small Cap Growth. Regional mutual funds also tend to focus on these smaller names as well, so consider offerings such as Matthews Pacific Tiger and Invesco European.
To find more possibilities, look for funds whose holdings have a median market capitalization below $5 billion and then scan the portfolio’s top holdings to make sure they include some unfamiliar names.
Information on holdings and their market capitalizations is generally available on fund-company Web sites or at sites such at Smartmoney.com or Morningstar.com.
