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."

    Rytoft says this trend is real and ongoing. He says Europe, which had a correlation of 0.82 with the Standard & Poor's 500 a year ago, has increased to 0.89 during 2004, according to Bloomberg data. "The fact is that the world is getting smaller, basically," he says. "Globalization is going on, and this means there is growing correlation with U.S. markets."

    Rytoft notes that it is the globalization of equity trading, not just of trade, that is spurring this trend. "It doesn't matter where you sit in this world, you can always trade stocks, at any time," he says. "Opportunities for arbitrage, any market inaccuracies, are taken advantage of immediately. So therefore we are seeing this increase in correlation."

    One between-the-lines read on the trend is that as companies around the world grow and mature, they recognize the need to attract international investment, says Krosby. Which means that they increasingly are becoming more like us.

    "As companies in Asia, for instance, want a broader range of investors, they're becoming more transparent," says Krosby. "They're understanding the concept of shareholder value. And as that trend continues, the money will find those companies. Say in Japan, even during their worst period, when it looked like they would never emerge from their deflationary spiral, there were a number of companies that offered marvelous opportunities. Because, despite the host of problems in Japan, those companies understood that they needed to restructure themselves."

    Krosby says advisors and their clients should be looking to fund managers to search for bottom-up changes-what is happening at the corporate level-and not just the top-down actions by governments. "Even though we see the markets moving more closely together, investing in international equities is the one way to get exposure to companies that are restructuring, regardless of the headlines about the countries they are in," she says. "That's the job of the international portfolio managers, to find those companies."

The Lure Of Emerging Markets

The trend to closer correlations has led many to emerging markets and small-cap international equities, accepting the higher risk in exchange for higher potential profits. "The way we believe you get the biggest bang for your diversification buck is with international small-caps," says Orecchio.

    While economic growth in Europe is slower than in America's, other regions offer significantly higher growth. "I think emerging markets probably look more attractive than developed overseas markets," says Eve Kaplan, who spent 20 years living in Asia and working as a portfolio manager, stock analyst and fee-only advisor before returning to the United States and starting a solo practice, Kaplan Financial Advisors, in Berkeley Heights, N.J., as a newly minted CFP certificant. "I wouldn't warn people away from developed overseas markets, but I do think there is more opportunity on the emerging side."

    But the enthusiasm is tempered by an appreciation of the risks in emerging markets, and particularly of small-cap companies in those markets. "Emerging markets are very attractive," Rytoft says. "But there's a reason they're called emerging markets. Things can happen."
   
    Advisors maintain it's important not to downplay the risks of venturing into nations and regions where their experience with the rule of law and free markets has been brief, and that they depend on the professionalism of the international funds, and the spreading of risk across funds, to provide balance and security. "We broadly diversify among countries and issues," reducing the impact of the inherent volatility, says Orecchio. "So if someone has a problem, like Malaysia in 1998, you're not hurt that much. ... We're buying the basket of stocks, not individual stocks."

    Krosby says advisors and clients should be looking for funds that offer a safe way to gain emerging market exposure. "In a true international fund, the portfolio manager typically has the ability to hold 10% to 20% of the portfolio in emerging market stock, typically on an opportunistic basis," says Krosby. "That gives the client exposure without truly being in an emerging market fund."
   
    World events are leading to what may be considered a new type of market, something between the typical emerging market and the developed countries.

    "Eastern Europe is a very special region," says Rytoft, whose fund specializes in countries that were part of the former Soviet bloc as well as in Russia, with some investments elsewhere in Europe. "You have some very old nations there, hundreds of years old. But in an economic sense they're around 15 years old. They are fairly new countries in terms of a market economy."

    Noting that eight more of these nations joined the European Union this year, Rytoft says, " For the first time, you have a group of emerging market countries becoming members of a major trade organization like this. At the same time, a number of them are holding investment-grade ratings, or are about to get it, and are moving to a common currency, the euro.

    "To my mind, this is a special situation," he says. "They're somewhere in the middle of emerging and developed markets. There is a transition or convergence taking place. ... That will probably create a new grouping."

How Much Of A Good Thing?
    The only hard and fast rule financial professionals agree on when discussing how much of an individual portfolio should be allocated to international equities is that they must be tailored to the investor's risk tolerance. Opinions ranged from a low of 2% or 3% for clients who are cautious about international equities, to a high of about a 50%-50% split between foreign and North American stocks.

    "We have no fixed percentage," says Orecchio. "We do a customization for each client. For our average clients it ranges from a smaller amount, about 2% to 3%, to as much as 15%."

    Kaplan says she also has a sliding range, depending on a client's risk tolerance. "It varies by clients, but I would say that for many people it makes sense to have anywhere from 10% to 20% of the portfolio in international holdings. That includes fixed income."

    Krosby says The Hartford has moved away from "that notion that it's a complete" diversifier. "We look at it as making sure that you're allocated across the board. I think it has to be very specific to each client. Some clients just don't feel comfortable having investments overseas, so we say widen their exposure to companies doing business overseas. But I think that 15% to 25% of a portfolio should be allocated to international as a broad rule of thumb, depending on a client's tolerance for anything foreign."

    Rytoft's assessment is near the high end, though several academic studies have supported it. "The U.S. is 54% of global stock market capitalization, so something like 50% in U.S. or North America is probably the right way to do that," he says. "Spread out the remainder, depending on how much risk you're willing to accept, and how much time you have going forward."

    Of that 50% international allocation, he says, about 8% should go into emerging markets. "The longer the range you're looking at, the higher you should go in emerging markets. The correlation factor is important, to have a piece of the portfolio that is less or negatively correlated to the U.S. It depends on your aggressiveness, and the time you have to flow it."

Where Are The Opportunities?
    So what advice should advisors be dispensing to their clients? For one, many professionals are not optimistic that the domestic market will provide significant gains for the foreseeable future.

    Stanasolovich thinks that domestic equities will provide only "low single-digit returns over the next decade on a pre-tax basis," while better opportunities await beyond U.S. borders. "Large international equities may add a percent or two (above domestic returns)," he says. "Small cap should add a couple of percentage points above that, and emerging market equities might add another couple of percent. So emerging markets might go to 8% returns while U.S. stocks might only do 2%. The fundamentals in the emerging market equities are better."

    But Stanasolovich maintains a cautious approach to emerging markets, avoiding a focus on any specific region. So too does Moffett, the UMB Scout WorldWide Fund manager, who says he focuses largely on investments in "Europe, the Americas and Canada, and some in Asia."

    "We start with the countries," Moffett says. "We're basically the developed economies, with what we think are stable governments. We're not deep into Russia and China, for example. ... We don't have anything in Africa and the Middle East-they're too hairy for us."
   
    Rytoft's focus, of course, is on Europe. "Europe is a more conformed group," he says. "All of the countries are moving in the same direction." He says that he expects Eastern Europe will continue to grow and "get to 80% to 90% of the level of the rest of Europe."

    He says that, ranking according to risk, he puts Europe first, then Latin America followed by Asia. "If you take general P/E levels, the U.S. is 17 roughly; Europe is at the 14 to 15 level, and Eastern Europe is at the 11 to 12 level. That's the rough breakdown."

    Krosby, too, feels that Europe is harboring a great deal of potential, which is largely being ignored by investors in the United States. "You had a situation where investors started to shun continental Europe, for the lack of capitalist spirit, if you will," she says. "As a result, I that think the valuations are becoming attractive. We're also starting to see governments dealing with these issues, and from the bottom-up aspect the companies are addressing this too."

    Without realizing it, Krosby says, we may be witnessing the beginning of the end of the social welfare compact that has dominated Europe since World War II. "They understand that they have to be competitive globally and domestically," she says. "You really are beginning to see a change in tone. Moreover, we saw companies in Europe, at the beginning of the downturn, announce restructuring, announce layoffs, and even though there was a political backlash the companies in fact went ahead with the restructuring and actually laid off people, in environments I never thought we could see."

    Krosby notes that European governments have been involved in ongoing debates over lengthening their short work weeks, one pillar in Europe's costly social system. "Even the top-line macro news coming out of Europe is incrementally changing. In essence, you are beginning to see the dismantling of the social contract with workers that allowed them the huge, huge benefits," she says.