Financial professionals look to international equities for earnings growth.

    War in Iraq. Terrorism everywhere. Gyrating oil prices. Where will economic and political consolidation take Europe? China's white-hot economy continues to steam up the global economy; Japan's continues to sleepwalk. Will the Asian subcontinent lurch into another potentially nuclear conflict between India and Pakistan?

    The only certainty in international news seems to be the uncertainty roiling bloc after regional bloc all the way around the planet. The experts and pundits seem to agree only that the future of the global economy is even more uncertain than what will be in tomorrow's headlines.

    But for financial professionals in the United States, there does seem to be one certain truth: The potential risks of investing in the international sector are outweighed by the absolute hazard of not properly diversifying client portfolios. If any one needed more evidence, the dramatic decline of the U.S. dollar last year provided the proof.

    "You definitely need to have diversification in your head as one of the most important words you can find," says Soren Rytoft, manager of the Metzler/Payden European Emerging Markets Fund. "You have to be diversified, and have portions of your portfolio invested in places in the world that have less correlation to the U.S. markets."

    There is broad agreement that portfolios must include international exposure. But as the American and international markets evolve, professionals find the nature and diversification factors of international equities are changing as well.
    The correlation between U.S. markets and larger companies in developed markets, and large-cap corporations around the world, has steadily increased in recent years. At the same time, expected modest potential for appreciation in the pricey U.S. markets for the foreseeable future combined with predictions of higher gains in cheaper international equities offer the possibility of increased returns in addition to diversification by investing overseas.
    "Overall, it's been very good in 2004," says Rytoft. "International equities are up 14% to 15% year-to-date (through November), while the S&P is up only 5% to 6% year-to-date."

    The widening interest in international equities among individual investors is well behind the move to greater exposure to international equities by institutional investors, says Quincy Krosby, chief investment strategist at The Hartford Financial Services Group Inc. "The retail money usually goes in last," argues Krosby, a former U.S. representative to the International Monetary Fund and Assistant Secretary of Commerce. "We've seen institutional money going into international for a number of years. The commitment has been there. ... People in the United States, over the last six months, have started to read articles on international investing, and the retail investor typically goes to the advisor and says, 'I've been reading about this.'"

Redefining Diversification?
    The combination of decelerating earnings in domestic stocks and the effects of the declining dollar make international equities a solid investment even beyond the diversification issue, says Jim Moffett, manager of the UMB Scout WorldWide Fund, an international multi-cap core fund. "In 2003 we had a very good year, and 2004 has been good," says Moffett. "Some of that is relative to the domestic stocks this year. And some of that is due to the currency, but that is one the reasons to invest abroad. That wind was at our back the last couple of years. The dollar has gone down, the euro has gone up, and that helps. That is part of the diversification you're looking for, too."

    Although international equities in total are still a must for diversity, many professionals note that large-cap corporations, and markets in developed countries, may not provide the level of diversity they once did.

    "They are highly correlated to the S&P 500," says Louis Stanasolovich, who is CEO and president of Legend Financial Advisors Inc., a Pittsburgh firm with 180 clients and more than $200 million in assets under management. "I've been in this business 20-plus years now. In the early '80s, the correlation was about 30%. By the '90s, it was about 50%. A lot of these companies are international businesses."

    "The large-caps, international large and U.S. large, are acting an awful lot like each other. Large companies, based in the U.S. or overseas, have become multinational corporations," says Tom Orecchio, CFA, ChFC, CFP, a partner in Greenbaum and Orecchio Inc., in Old Tappan, N.J., which has 130 clients and $185 million in assets under management. "The overseas large-caps are affected as much by what happens in the U.S. as by what happens in their home countries."