The case for an all-domestic portfolio.

Efficient-market theoreticians have long maintained that there are two reasons American investors should invest some of their money overseas: diversification into non-correlated markets and exposure to an increased opportunity set. In my work as an investment advisor to American retirees, I have found these arguments wanting.

E Pluribus Diversificationis

After being dismissed by the New Economy cognoscenti as an anachronism, diversification has recently been rescued from the dustbin of financial history and reinstated as the one truly viable religion of portfolio management. The more non-correlated asset classes you own, adherents maintain, the less likely you are to be blindsided by a rout in your favorite investments. And the less likely you are to be faulted for straying from the performance attributes of some great, transcendent benchmark.

That's OK as far as it goes. But the advisor should realize that to base one's investment style on the importance of constraining volatility via maximum asset-class diversification is to subscribe to corollaries that you may not be so eager to embrace.

For example, are you prepared to state unequivocally that you are incapable of adding value to your clients' portfolios by the exercise of your judgment? (By adding value I mean reducing volatility, enhancing returns or both.) If that is your belief, you will enjoy the support of luminaries such as John Bogle, who is only lukewarm about the benefits of international investing, and other illustrious acolytes of indexing and efficient-market orthodoxy. But if you pledge allegiance to this creed, you must also be prepared to match fees with computerized allocation services, which can index and rebalance as well as you or better. Or else you will need to justify your fees almost entirely on the basis of non-investment services.

A Different Value Proposition

In spite of, or perhaps because of, my 38 years of experience as a professional investor, I remain an unapologetic proponent of active portfolio management. I believe that investment markets are more emotional than rational in the short run, which causes glaring inefficiencies in the valuation of entire asset classes from time to time. I believe that intelligent people who are experienced in the workings of the investment markets are capable, by the disciplined exercise of their judgment, to make better decisions with respect to the real value of asset classes (and securities, for that matter) than either amateurs or professional indexers who believe that they are incapable of making wise allocation decisions. I believe it is possible to perceive inefficiencies and to take advantage of them.

Think back to the last final two years of what we now call "the bubble." In your heart of hearts, did you believe that Nasdaq was worth 200 times earnings? Or did you really believe that valuation no longer mattered? If you did continue to ride the new economy rocket in those heady times, despite misgivings, my guess is that you stayed the course because that is what was working at the time; because you saw traditional value managers losing their jobs; because your clients were ecstatic; because the efficient-market cognoscenti convinced you, against your better instincts, that you could never know enough to go against the all-seeing "market." Rising prices made you feel like somebody knew something you didn't.

I think you can be better than that. I think you are capable of making a judgment that this or that asset class is or is not a good value, especially at valuation extremes. There are times when you can say with conviction that this or that asset class is or is not priced within a range that can be described as "normal." Looking back, if you realize now that you did know we were in a bubble, but did not adjust your portfolios because the efficient-market culture convinced you that you had no business making a call like that, then you are smart enough to add value by your investment judgment.

I also believe, that as a personal financial advisor to real human beings, you are capable of understanding clients' goals, expressing those goals in financial terms, and designing a portfolio appropriate to the achievement of those goals. All of these together-the listening, the translating and the investment judgment-constitute a value proposition that no computer can match, a value that justifies your fees.

I mention the experienced personal financial advisor's value proposition by way of introducing this column's subject: why I currently choose not to invest my retired clients' money overseas. I am convinced neither that foreign investing provides appropriate diversification at a reasonable cost, nor that it provides a reasonable opportunity to enhance returns in my clients' portfolios.

The diversification police may not be concerned with the following information, but it is a fact that Morgan Stanley's EAFE index outperformed the S&P 500/Barra growth index in only five of the most recent 15 years, and in only one of the last eight years. More interesting to me is that for those 15 years, the EAFE's 5.8% compound rate of return paled next to the 14.1% compound return for large-cap U.S. growth stocks. For this I should take a currency risk? If diversification is the goal, I note that the Lehman Bros. Aggregate Bond Index also beat large growth stocks in five out of 15 years, but its compound return for those 15 years was a robust 8.1%. And that's in dollars!

The Currency Issue

Every year most of my retired clients withdraw dollars from their portfolios. So, ultimately that is what I need to help them earn: U.S. dollars. If we invest abroad, we will earn euros or yen or yuan, and we will have to convert them into greenbacks at some point in the future. That means that if we invest in international mutual funds or foreign securities, we have to accept a currency risk; a risk that while we have our money tied up in foreign denominations, those currencies may lose value relative to the dollars that we eventually need to convert back to. I could make an otherwise successful investment overseas only to see my gains impaired in the currency conversion process. The only alternative is to hedge the currency risk or to invest in foreign mutual funds that hedge the currency risks for me. My experience is that hedging is fairly expensive and is not always effective.

So I ask myself, "Under what circumstances would I take a currency risk or accept the considerable cost of currency hedging?" The only logical reply is that I would undertake the hedging cost or currency risk of investing overseas only if I perceived an opportunity for excess returns; an opportunity that is not available in dollar-denominated investments. I am currently having a little difficulty identifying such an opportunity.

Over the years, I have invested in foreign securities via international mutual funds. For the most part these have not been satisfying forays (more forthrightly, I lost a lot of money). But I have learned some valuable lessons.

In the mid-1990s, I invested 5% to 10% of our portfolios in emerging market funds. My logic was pretty straightforward: Those economies were growing two to three times as fast as our own in inflation-adjusted terms; furthermore, their global competitive advantages and relatively low standards of living made those growth rates look sustainable. Even if the selected mutual fund managers overpaid for securities, I reasoned, the rapid economic growth rates in those nations would eventually bail us out. I now realize that my logic was tragically flawed.

Rapid growth of a nation's economy does indeed create opportunity for companies to expand. But their expansion needs to be funded either by strong returns on invested capital (e.g. a high ROE) or by accessing the capital markets. If companies fund their growth by selling more shares to eager new investors, they may very well experience an attractive growth of sales and profits. But, because of dilution, their earnings-per-share may increase slowly or perhaps not at all. The original shareholders will only prosper in the long run if the company earns a high return on invested capital. A superior economic growth environment is, alone, an insufficient reason for investing dollars in a developing economy.

Opportunities Abroad?

Call me parochial, but the argument that broadening our investment horizon to include countries beyond our borders will enhance our results seems even less compelling than the diversification shtick. As noted above, EAFE Index returns have been poor relative to those in the U.S. The reasons are different in different parts of the world, but I believe they share a common aspect: Nobody does freedom like the United States.

We have corporate transparency issues. We have terrorism. We have debt problems. But we also have a system of accountability, a media bent on exposing crooks, a legal framework for dealing with wrongdoing, and a culture that allows both success and failure on the merits for each person and each enterprise. Ultimately, our entrepreneurial economy is more adaptive than those in which government insulates favored businesses from competition or from the natural consequences of poor decisions.

China sports a real economic growth rate of something like 8%. Its trade surplus with the U.S. is surging. We harbor suspicions about the legitimacy of their low wage costs, but U.S. consumers do not hesitate to load shopping carts with China's attractively priced output. Should we invest in China? China region funds were down 11% for the first 11 months of 2002, less than U.S. stocks, and lost 8% a year for the last three years, which isn't so awful, I suppose.

But there is a huge debt problem lurking beneath the surface, one that could prove devastating to owners of Chinese equities. That nation's central bank estimates that 25%-30% of bank loans are not current. Outside sources place the likely defaults at between 25% and 50% of GDP. To put that in perspective, the S&L crisis in the U.S. at its height involved bad debts equal to less than 5% of GDP.

Japan, of course, is also trying to cope with its own corporate deadbeats. A writer in the Asian Wall Street Journal recently placed the island nation's bad loan burden at 75% to 100% of GDP! Referring to the cozy relationship between government and major banks that covered up poor credits for years, a recent WSJ editorial claimed, "Bureaucrats have run Japan into the ground."

Several years ago, it seemed to me that Europe might present one of those wonderful investment opportunities that are not available in the U.S. P/Es were lower than ours, and the unification efforts seemed to be ushering in a strong trend away from socialist policies and toward free-market democratic capitalism. If the experiment were to succeed, I reasoned, European corporations would become more competitive, and its work force more productive. Growth would rise and public interest in investing could mushroom as it has in the United States. I thought I just might be getting in at the start of another great bull market! But, alas, as Euroland struggles to emerge from the recent recession, its politics seem to be shifting left again. Protectionism and its corollary, double-digit unemployment, appear intractable after all. So I am giving up on Europe's willingness to imitate our successes.

Are there investment opportunities abroad? Undoubtedly there are. Am I able to perceive them? Not so far. Are there mutual fund managers or teams that I can depend on to ferret out these opportunities for us? I'm not sure. But if the cost is 2% or more in annual mutual fund expenses plus currency risks or hedging costs, then I am from Missouri on that one.

There are approximately 11,000 public companies to choose from in the United States. Is my opportunity set so limited that I need to risk my retired clients' assets in foreign currencies, in nations where I have more serious misgivings about transparency and corporate governance than I have at home, and where the dominant business culture is far less adaptive than it is here?

Baseball fan Warren Buffett likens investing to standing at the plate waiting for a good pitch. But in investing, he says, nobody is counting balls and strikes. You don't have to swing until you see one you really like. I am standing at the plate on behalf of my retirees. The foreign investing pitch looks to me like it is low and outside. I'm not swinging.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.