International Investing Made Easy
by Mark Biller
April 10, 2006
(AgapePress) - - The conventional wisdom has long held that a well-diversified portfolio should include stocks from foreign countries. The rationale is two-fold. First, owning foreign stocks offers more exciting growth opportunities than investing exclusively in U.S. companies. After all, strong as the U.S. economy may be, it's still a relatively small fraction of the world economy. Second, owning foreign stocks has long been thought to provide a diversification benefit. Ideally, when the U.S. stock market zigs, your foreign stocks will zag, offering you more stability overall than a portfolio comprised solely of domestic stocks.How have these arguments held up over time; and more importantly, what do their prospects look like for the future? Regarding the diversification benefit of foreign stocks, the jury is still out. Looking back over many years, there has indeed been a benefit to owning foreign stocks, in terms of absolute returns as well as dampening volatility. However, that effect has been muted over the past 15 years or so. In recent years, foreign stocks have risen and fallen much more in unison with our own market, diminishing their diversification benefit.
There are at least two good theories that attempt to explain why this has been the case. One is that the world economy is much more interconnected now than ever before. Governments work more closely together in implementing economic and trade policies, and technology has lowered or entirely removed the barriers that used to restrict the flow of money across national boundaries. None of that is likely to change.
The second theory is simply that the technology bubble of the late 1990s distorted the usual domestic/international patterns by first inflating and then bursting the fortunes of technology companies both here and abroad. That factor was significant enough to make all stock markets look rather similar for several years while it played out.
It's possible that both of these theories are true to some extent. If so, while there should be a continuing diversification benefit from owning foreign stocks, it may not be as great as in the past. Only time will provide a definitive answer.
If the diversification aspect of owning foreign stocks is questionable at this point, what about the opportunity angle? On this point, there's certainly an interesting case to be made in favor of foreign investing. First though, a warning: experts have been predicting the demise of U.S. business at the hands of foreign competition for years, and it hasn't happened yet. But thinking it through, there's no question that America faces some significant challenges that our most likely challengers in the 21st century do not. The Congressional Budget Office predicts that if our entitlement programs aren't reformed, the government's share of GDP will approach 50 percent by 2030. In addition, our healthcare costs are already high and moving higher, and we have the overhang of a zealous (some might argue out-of-control) tort system weighing on our business competitiveness.
Contrast this to the economies of China, India, Taiwan, Singapore, and the other "Asian Tigers" where growth is higher than in the U.S., supplies of educated labor are deep and cheap, few healthcare benefits are provided, and the tort bar is virtually non-existent. Given those comparisons, it's not hard to argue that a considerable part of the market action over the coming decades is going to be outside our own shores. That's not to say we should stop investing domestically -- American business certainly has a lot going for it, not the least of which is simply a head-start. But it seems wise to diversify abroad as well.
If that's true, and an investor wishes to invest internationally, there are three main groups of mutual funds to consider. Here at Sound Mind Investing, we include each group separately in our monthly "Fund Performance Rankings," and it's worth noting the differences:
Global funds normally allow their managers to invest anywhere in the world where they find attractive opportunities, including in the U.S. A global fund may own very few foreign stocks or may own an almost exclusively foreign portfolio. In Sound Mind Investing's model portfolios, we allocate a certain amount of money specifically to be invested internationally. Since we can't really count on a global fund to invest all of that allocated money abroad, we tend to shy away from these funds. We prefer funds where we know all the money is invested internationally -- that way we're in control of our overall allocation decisions rather than leaving it in the hands of fund managers.
Foreign funds invest nearly exclusively outside the U.S., and will typically have no more than a few percent of their assets in U.S. stocks. It's up to the discretion of each individual fund whether to set any limits on how large a percentage of assets can be invested in any single country or region. But normally this group is the place to look if you're interested in investing across a number of countries and regions through a single fund. In our view, this is the ideal scenario, as it allows the foreign fund manager -- who we're counting on to be the expert -- the ability to move money around the world to whatever areas he/she thinks offer the most promising conditions.
There's a large range of volatility among these funds -- our current rankings show some that have been 30 percent less volatile than the S&P 500, while others have been as much as 50 percent more volatile. Volatility is dampened in this group by the usual tendency of the manager to spread money across a number of countries and regions so an unexpected event in one particular country doesn't ding the overall fund too much. As Table A shows, there hasn't been a notable difference in volatility in recent years between the global and foreign funds in our rankings. The primary difference is the presence or absence of U.S. stocks in these funds.
Regional funds are the wild child of the international scene. These funds may focus on one specific country or a particular region. We also lump into this group the "emerging market" funds that focus exclusively on the smaller, more volatile markets. If international investing is like going to an amusement park, these regional funds are the big roller coasters, capable of wild thrills and breathtaking drops. This shouldn't be a big surprise, as they focus on smaller, less stable overseas markets, and typically have relatively little diversification. It's easy to see how all the stocks in a hypothetical Taiwan fund would plummet in unison if China started preparations for an invasion. Money can be made and lost in a hurry with these funds, making them speculative tools that we generally don't recommend for most investors.
Given that the earlier case for international investing was largely built on the appeal of the Asian markets (excepting Japan), some might reasonably conclude that a Far East regional fund would be the best way to play this expected trend. But Sound Mind Investing readers have a secret weapon in their foreign investing toolbelt. Okay, it's not really secret -- it's the momentum system our Upgrading strategy is built upon. The beauty of Upgrading applied to international funds is that it releases us from having to predict which areas will be hot and when. We pour all the foreign funds into the top of our momentum funnel/filter, and let the upgrading process tell us which combination of countries, company sizes, and investing styles is working best at any particular moment. If our earlier Asian hypothesis comes true, our Foreign Category rankings will be dominated by funds focusing in those countries. If not, and Europe or some other country/region surprises us, we'll nimbly move our money into those funds that are capitalizing on those trends.
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. To see how their specific saving and investing advice can benefit you, visit them online.
