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.