December 6, 2004

BY RUSS WILES

The boat has come in for international mutual funds this year. Helped by a falling dollar, many foreign stock markets have generated higher returns than what's available domestically.

The typical foreign fund tracked by Lipper Inc. gained 13.2 percent on average over the first 11 months of this year compared with 8.2 percent for funds that hold broadly diversified portfolios of U.S. stocks. But whether the trend persists into 2005 is a matter of debate.

"The easy money has been made," said Kunal Kapoor, director of fund analysis for Chicago researcher Morningstar Inc. "The portfolio managers we talk to say overseas valuations are still attractive, but not as attractive as they were."

Carl Birkelbach, chief executive of Birkelbach Management Corp. in Chicago, also takes a so-so view of overseas opportunities. "Foreign markets will perform well, but not as well as the U.S. market, which could show some surprises on the upside," he predicts.

Boost from the greenback

Part of the big recent gain in foreign investments has been paved by a weaker dollar. When the greenback loses ground against other currencies, the value of foreign investments, including mutual funds, rises from the perspective of American investors. By contrast, a rising dollar produces an investment headwind.

In recent months, the dollar has been dropping in currency markets, most notably against the euro, which is trading near record-high levels. Over the past two-plus years, the dollar has fallen roughly 50 percent against the euro, 30 percent against the British pound and more than 25 percent against the Japanese yen.

In light of such sharp moves, Birkelbach views the dollar's slide as "overdone." A greenback rally from current levels, if it happens, would undermine returns on foreign investments.

A solid case also can be made in favor of foreign companies, many of which are just now pursuing the cost-cutting strategies that American corporations have mastered.

"I would suggest that this start of growth that we've seen, in terms of earnings, is going to go on for a while overseas and is going to look relatively better than we see in the U.S.," said David Antonelli, chief equity officer for MFS Investment Management in Boston.

Foreign stocks also look cheaper than their domestic counterparts, he argues, trading at 68 cents on the dollar compared with U.S. companies on a price/cash flow basis.

Besides, foreign markets tend to either lead or lag U.S. stocks for several years at a time, said Thomas Melendez, an international portfolio manager for MFS. Foreign outperformance mainly has come over the past few years, suggesting there's further upside potential ahead.

In reality, the foreign/domestic question isn't an either/or issue. Investment advisers routinely suggest people maintain stakes in both areas.

"International investing should be a part of everyone's portfolio," Birkelbach says. As a general rule, he suggests placing 15 percent or so of a portfolio in the foreign area.

In fact, institutional investors such as pension funds hold about 15 percent of their assets in international markets, said Melendez, yet the typical individual has less than 3 percent, based on a study of 401(k) accounts.

"Over 60 percent of U.S. individual investors have zero exposure to international markets," he said. "We find that surprising."

Thanks to mutual funds, it's not hard for mainstream investors to gain a toehold in foreign markets.

Getting started

Kapoor's favorites include Causeway International Value, Dodge & Cox International, American Europacific Growth and Artisan International.

Other funds with good, long-term records include Fidelity International Discovery, Julius Baer International Equity and Vanguard International Value. Various foreign-flavored exchange-traded funds also can make good choices.

With the world shrinking every day from globalization, it's smart to have exposure to overseas markets. But because some such markets are relatively unstable, and because foreign funds introduce the extra element of currency risk, it's wise to be patient with such holdings and take a long-term perspective.

Russ Wiles is a financial writer and columnist for the Arizona Republic and author of the book How Mutual Funds Work (Prentice Hall, $15.95). Direct your questions to Russ Wiles, the Arizona Republic, P.O. Box 1950, Phoenix, Ariz. 85001.