Here's what to consider when selecting
international funds.

    Over the past year through the beginning of October, total return on U.S. stocks was 10.22%, according to Morgan Stanley Capital International. Three- and five-year annualized returns were 11.36% and 6.48%, respectively. Not bad, except when you consider what's been happening abroad.
    MSCI's international benchmark index, EAFE (tracking European, Australian and Far Eastern markets), has more than doubled the U.S. index in dollar terms, rising 20.50%, 21.93% and 14.81% over the same periods. European markets alone are up even more, soaring 23.57%, 23.90% and 15.37%, respectively.
    Even those financial advisors who have stubbornly refused to look beyond our shores are grudgingly realizing that the only way to gain significant performance is by venturing offshore. With this shift in strategy has come the realization that portfolios that aren't adequately diversified geographically can often more risky than those that are thoroughly domestic in focus.
    One key reason is that markets are always in different phases of the economic cycle. According to Steve Rubel, senior vice president of Janney Montgomery Scott LLC, "Having exposure to different economies helps ensure greater overall balance, because while some markets are slowing down others will be growing."
    And advisors are even becoming more sanguine toward what was the bane of international investing-foreign currency exposure. Iain Lindsay, of Goldman Sachs Asset Management's Global Fixed-Income and Currency division in London, explains that "long-term active currency returns are driven by a range of economic factors that differ from those driving equity and bond returns, which makes foreign exchange an essential component of portfolio diversification."
    Certainly, the benefits of international diversification are nothing new. The classic Efficient Frontier Theory has postulated for quite some time that the ideal risk-reward model involves a 30% allocation to international markets. The key question is how to get that allocation.
    Over the past several years, investing in virtually any foreign fund has helped advisors outperform the U.S. market. There is a certain parallel between the way foreign markets have performed over the past five years and the boom in U.S. large-cap shares in the late 1990s. But doing one's homework can make a difference. And we see that by looking at two large-cap name-brand funds: Merrill Lynch and Julius Baer International Equity Funds.
    Recently rebranded the BlackRock International Fund with annual expenses of 1.98%, the Merrill Lynch fund has dramatically underperformed EAFE. Even when excluding the front-load sales charge of 5.25%, one-year returns through October 2 were 8.61%, 669 basis points behind EAFE. Three-year annualized returns were 16.96%, 449 basis points behind EAFE. And five-year annualized returns of 10.29% were 408 basis points behind EAFE.
    Julius Baer International Equity Fund gets a head start by being a no-load fund with an expense ratio of 1.31%. But superior asset allocation and stock selection has enabled the fund's total returns to soar past BlackRock, with one-, three- and five-year annualized returns of 20.24%, 24.08% and 18.80%, respectively. And when you drill down a bit further into these blend funds, it appears that Baer's managers have been able to discern better value. According to Morningstar, the Baer fund has lower price-to-book, price-to-sales, price-to-cash flow and forward P/E ratios, while enjoying higher long-term earnings and cash-flow growth.
    Many seasoned advisors have an intuitive sense of essential considerations when choosing international funds (see sidebar). This allows them to keep things simple: achieving effective international exposure through a minimum number of funds.
    Greg Werlinich, president of Werlinich Asset Management, a fee-only advisory based in suburban New York, has 6% of his $52 million fee-based assets in foreign securities. Familiar with foreign stock investing, he has nearly 90% of his international exposure in American Depositary Receipts. Investing the remaining portion in foreign funds, he looks for no-load products with below-average annual expenses. For international equity funds, he believes they shouldn't top 1.5%. For bond funds, they shouldn't exceed 1.25%.
    Werlinich searches for proven management tenure of at least five years and focuses on relative returns during times in which markets have stumbled. And he believes that the quality of the investment process is largely revealed in the rate of turnover, which he prefers seeing below 50%.
    While he buys open-end funds and ETFs, he currently has two thirds of his foreign fund assets in two closed-end funds that focus on income and foreign currency exposure: Templeton Global Income Fund and the Morgan Stanley Emerging Market Debt Fund. The funds currently yield 5.5% and 7.2%, with five-year annualized returns of 14.70% and 18.45%, respectively.
    He finds foreign exchange is a more important factor affecting returns than the changing spread between a closed-end fund's market and net asset values. And Werlinich believes the dollar will continue to decline, making foreign securities worth more, providing these funds with an extra kick.
    With $38 million of assets, Charles Failla, principal of the New York-based Sovereign Financial Group, was originally reticent about foreign exposure when he started up his fee-based operation in 1999.  "Back then," he explains, "I thought U.S. securities to be safe, familiar, proven territory that rewarded investors who remained faithful."
    But after the bear market of 2000-2002, Failla began seeing the benefits of increased foreign exposure, especially with the advent of ETFs, which made venturing abroad easy, inexpensive, transparent, tax efficient and liquid.
    He has been pushing up his foreign exposure, which currently stands at 20% of assets. He says it could reach 25% if these investments continue to outperform his domestic holdings.
    He maintains an 80/20 split between developed and emerging market equity exposure. Since establishing his developed market position with Barclays' no-load iShares EAFE ETF in January 2004, with annual expenses of 35 basis points, he's realized annualized returns of 23% through September 22, 2006. And his 20% exposure in iShares' Emerging Market ETF, with expenses of 75 basis points, is up 32% during the same time.
    Registered rep Steven Rubel of Janney Montgomery Scott believes finding the right fund family is the best way to go. "For me," Rubel explains "American Funds provides a variety of fund choices that are transparent with low expenses, and long-term management that during my 30 years with them have delivered above-market returns."
    He invests a low-double-digit percentage of his $130 million in assets in foreign securities, two-thirds of which are spread across three large-cap funds to achieve effective global allocation. He uses class "A" shares, explaining that they typically generate the best returns by getting the sales fee quickly out of the way and offering the lowest annual expenses, which re all under 77 basis points.
    The majority of his foreign fund exposure is in American Funds' value-oriented New Perspective Fund, with nearly two-thirds of its assets in international stocks. According to Morningstar, its five-year, nonload-adjusted annualized return through October 2 was 12.45%, or 209 bps above the MSCI World Index. Rubel has additional exposure in the dividend-focused Capital World Growth & Income Fund, whose five-year, nonload-adjusted annualized return of 16.18% is 577 bps above the World Index. And Rubel also is invested in the EuroPacific Growth Fund, a pure international capital appreciation play. Its nonload-adjusted, five-year annualized return of 15.42% tops EAFE by 105 bps.
    Rubel leaves the issue of currency exposure up to the funds' managers, explaining that FX is part of the foreign investing process. "They've proven their worth over several decades I've used them," says Rubel, "and that makes it easier to have faith in what they're doing."
    Regular rebalancing of international allocation would prevent overexposure to foreign markets and lock in a portion of profits. But with so much opportunity beyond our shores, most observers believe that investors should continue to be well served by maintaining 10% to 20% of their assets intelligently spread across the globe in established transparent markets.