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.
