International Funds Off to Strong Start

Mutual funds that invest in foreign stocks have been disappointing U.S. investors for years. Will 2002 be any different?

Many international-investing pros think this may be foreign markets’ year. And foreign stocks overall are off to a strong start.

Three of the five best-performing stock fund categories in the first quarter were funds that invest overseas: Latin American funds; funds that own Asian stocks other than Japanese issues; and diversified emerging-markets funds, which can own Latin American and Asian stocks as well as those in Eastern Europe and Africa.

The emerging-markets category was up 11.9% for the first quarter, Asian funds rose 9.7% and Latin American funds gained 8.7%, on average, according to Morningstar Inc. Those categories also were among the best performers in the fourth quarter.

Both emerging-markets and Latin American funds got a boost from Mexico, where the stock market rose 17% in the first quarter.

Overall, the average international stock fund gained 3.9% in the quarter. In contrast, the average U.S. stock fund was up 0.4%.

Some financial planners are cheering the divergence in performance between U.S. and foreign funds as evidence of what they’ve long contended: Investments in foreign stocks can help diversify a portfolio and lower risk for investors by boosting returns when domestic markets lag.

But even some big fans of foreign stock investing caution against overdosing on international funds. The United States, despite accounting scandals and lackluster returns so far this year, probably won’t lose its status as the world’s premier market any time soon, especially if the economy continues to rebound.

What’s more, the strong dollar--a major drag on foreign returns for U.S. investors since the early 1990s--could continue to mute any gains foreign markets produce.

“I think there is some value to be had by looking overseas,” said David Bowers, chief global strategist at brokerage Merrill Lynch & Co. “But I don’t think we have the ‘full Monty’ of factors [to support a major overseas rally].”

Foreign stock fund returns have trailed the Standard & Poor’s 500 index for 10 of the last 12 years, typically by double digits. Last year, for example, foreign stock funds on average lost 22%, compared with a 12% loss in the S&P; 500.

Even in good years, foreign stock funds often have been eclipsed by the U.S. market. Case in point: Foreign funds’ 13.5% average gain in 1998 was overshadowed by the S&P; 500’s 28.6% rise.

The strong dollar has been a perpetual problem, reflecting global investors’ hunger for U.S. assets. Just as a foreign currency buys fewer greenbacks when the dollar is strong, foreign stock returns are reduced proportionately when the dollar rises in value.

For example, the Italian stock market’s 3.1% rise in the first quarter was reduced to 2.1% for U.S. investors, after accounting for the dollar’s rise against the euro.

Particularly disturbing to some analysts is that foreign markets in recent years have moved in tandem with the U.S. market--blunting the argument that foreign stocks could reduce a portfolio’s volatility.

“They’ve under-performed, relative to the U.S., and they haven’t given you the diversification you thought you were going to get,” Bowers said.

Nonetheless, some experts maintain that foreign stock funds can build on their first-quarter gains and have more room to climb than U.S. stock funds.

The U.S. has lost some of its cachet as the most-trusted financial market, in the wake of the Enron Corp. collapse and other accounting scandals, said Jay Pelosky, global strategist for brokerage Morgan Stanley.

That could make investments in foreign companies--traditionally considered less transparent in their accounting methods--seem less risky, Pelosky said.

Still-low interest rates and a global economic recovery also may help many countries more than the United States, strategists said.

U.S. consumers and companies have big debt loads, which could slow the pace of the domestic economy’s recovery, said Charles de Vaulx, co-manager of First Eagle SoGen international funds.

“The fundamentals in Europe are better than in the U.S.,” De Vaulx said. “U.S. consumers are overextended ... and corporations in Europe have better balance sheets than their U.S. counterparts.”

Furthermore, U.S. stocks are still pricey by classic market measures, many experts say.

“The U.S. is relatively the most expensive market in the world,” Bowers said. Even after its big drop over the last two years, “the Nasdaq composite index is trading at 90 [times projected earnings per share], while emerging markets are trading at 11 to 12 times.” The S&P; 500 is priced at about 23 times estimated 2002 earnings.

What about the strong dollar? Pelosky is among many pros who expect the buck to weaken over the next two to three years if the global economy revives and more investors become interested in foreign assets over U.S. assets.

A weaker dollar automatically would make foreign stock portfolios appreciate in dollar terms, all other things being equal. In fact, the dollar did weaken in the first quarter against some Asian and Latin American currencies.

Several brokerage firms, including Merrill Lynch and Morgan Stanley, recently trimmed their recommended allocation of U.S. stocks, reflecting the view that foreign stocks could do better than domestic shares in coming months.

Still, most strategists don’t see the catalyst that could send investors stampeding from the U.S. to the markets of either of the two other leading economies: Japan and Europe.

In the first quarter, the average European stock fund was up 1.1%. The average Japanese fund gained 2.8%. Those gains beat the average U.S. fund, but last year the average European fund plunged 21% and the average Japanese fund slumped 30.4%.

Even this year’s rally in emerging markets probably will fizzle at some point, because the risks involved will keep professionals from committing more than a small portion of their portfolios to emerging-market stocks, Bowers said.

“‘Sell U.S. and buy Russia’ doesn’t quite work,” Bowers said. “You’ve got to have a pretty powerful story to move capital away from the U.S. markets, and that’s still missing.”

In any case, emerging-markets funds should be approached with caution, analysts say. The funds are highly volatile--four times more likely to incur losses of more than 10% in a quarter than the typical foreign stock fund, according to Morningstar.

Most investors are better off using larger, more diversified international or global funds, such as American Funds EuroPacific Growth, Artisan International, Harbor International, Liberty Acorn International or Tweedy Browne Global Value, said Morningstar analyst Gregg Wolper. (Funds classified as foreign invest almost all their money abroad. So-called global or world funds may invest some money in U.S. markets.)

Investors who want to take a bit of a gamble on emerging markets, without risking losing their shirts, can consider diversified foreign funds that have significant stakes in developing countries, experts say. American Funds EuroPacific Growth, for example, recently had 19.5% of its assets in emerging markets. Another top performer, First Eagle SoGen Overseas, had 17.2% in developing markets.

That strategy has paid off for financial planner Ross Levin of Minneapolis, who kept his clients partly invested in foreign stock mutual funds throughout the 1990s, even as returns on foreign shares mostly lagged.

Levin said he minimized his clients’ ire by investing in some of the best-performing international funds, such as First Eagle SoGen funds and Artisan International, which often produced gains when their peers were losing money.

He believes foreign stocks will start outperforming U.S. stocks, just as U.S. stocks beat out foreign shares for most of the 1990s.

“The worse foreign stocks did, the more I liked them,” Levin said. “I’m a big believer in reversion to the mean.”