Why Investors Should Put up to 30%
Of Their Portfolio in Foreign Funds

It is time to expand your horizons.

Just 13% of stock-fund assets and 2% of bond-fund money is parked in mutual funds that invest partially or entirely abroad. It is hard to see these figures rising much in the years ahead, especially after all the revelations about market timers taking advantage of foreign-fund investors.

And yet the case for investing abroad is stronger than ever, thanks to a burgeoning array of foreign funds that promises to reduce a portfolio's risk and possibly boost its return. Indeed, I believe investors should earmark as much as 30% of their stock portfolio and 15% of their bond-market money for foreign funds.

Just a few years ago, if you were looking to invest abroad, you would probably have been told to buy a single foreign-stock fund that focused on big European and Asian companies, with maybe an additional sliver in an emerging-market stock fund.

Today, by contrast, anybody investing abroad should seriously consider buying funds from five categories. To tap into developed foreign markets like Britain, Germany and Japan, you might invest in three funds: a large-company foreign-stock fund, a small-company-stock fund and an international-bond fund. Meanwhile, to get exposure to Brazil, South Africa, Turkey and other developing countries, purchase two more funds, an emerging-market stock fund and an emerging-market debt fund.

HEDGING YOUR BETS Below, you will find the correlations between U.S. stocks and bonds and five foreign funds. If the correlation is close to 1, the two investments often rise and fall together, while a negative number suggests the two tend to move in opposite directions. FUND U.S. STOCKS U.S. BONDS Int'l large-cap stocks 0.8 –0.13 Int'l small-cap stocks 0.53 –0.18 International bonds 0.03 0.48 Emerging-market stocks 0.71 –0.20 Emerging-market debt 0.58 0.1 Source: T. Rowe Price Associates

Lately, large-cap funds that focus on mainstream foreign markets have taken a beating from the pundits. Their contention: Because U.S. and foreign markets often rise and fall in lockstep, you don't get much diversification by adding a large-cap foreign-stock fund to a U.S. stock portfolio.

But despite this increased correlation, it is still worth having exposure to both markets, according to a study by Meir Statman and Jonathan Scheid. The fact is, large-cap U.S. and foreign stocks often generate vastly different annual returns. Over the past 20 years, there were 13 calendar years when there was at least a 10-percentage-point difference between the performance of U.S. and foreign stocks.

"I think there's a dislike of foreign stocks," says Mr. Statman, a finance professor at Santa Clara University in Calif. "People are looking for an excuse to avoid them."

Even if you doubt large-cap foreign funds will help your portfolio, that doesn't mean you should give up on foreign investing. Instead, you ought to get even more adventurous.

To that end, consider a small-company foreign-stock fund, suggests Nelson Lam, an investment adviser in Lake Oswego, Ore. "International small-cap companies have the benefit and problem of dealing in their local economy and their local currency and, as a consequence, give you much better diversification," he argues.

Mr. Lam is also a big fan of both international-bond funds and emerging-market debt funds. In recent years, emerging-market debt funds have been especially strong performers, posting dazzling gains even as emerging-market stock funds have struggled.

Despite the weak performance, I would invest 5% of your stock portfolio in an emerging-market stock fund. As the population in Europe, U.S. and Japan ages, the burden of producing the world's goods will fall on the developing world, with its younger population. That should mean rapid growth for developing countries and hence healthy returns for emerging-market funds.

Intrigued? Unfortunately, our story doesn't have an entirely happy ending. The five fund categories are "all legitimate asset classes," says Larry Swedroe, research director at Buckingham Asset Management in St. Louis. "The question is, do investors want to invest in them?"

The problem: There aren't a whole lot of funds on offer and many of them trade too much and charge hefty investment costs.

For small-cap international exposure, Mr. Lam suggests Third Avenue International Value Fund and Vanguard International Explorer Fund. But the Third Avenue fund, which has a $2,500 investment minimum, charges a stiff 1.75% in annual expenses. At 0.72%, the Vanguard fund's expenses are more reasonable. But its investment minimum is a hefty $10,000, though individual retirement account investors can get in for $1,000.

Vanguard Group also offers a low-cost emerging-market stock-index fund. But if you want an actively managed fund with reasonable expenses, there aren't a lot of good choices. Mr. Lam suggests no-load SSgA Emerging Markets Fund, which charges 1.25% in annual expenses.

Meanwhile, for bond exposure, you might try Baltimore's T. Rowe Price Associates. Among its offerings are an emerging-market debt fund that levies 1.1% a year and an international-bond fund that charges 0.92%.

Reluctant to buy foreign funds because of the market-timing scandal? Clearly, you don't want a bunch of traders damaging your results. With that in mind, find out what efforts a fund makes to limit trading. The tougher the restrictions, the happier you should be to buy the fund.

Updated November 26, 2003 12:36 a.m.