May 14, 2006
Fundamentally
Foreign Stocks and the Allure of Double-Digit Growth
By PAUL J. LIM
WHENEVER an asset class performs exceedingly well, investors invariably come up with an endless list of reasons they should own more of it — and convince themselves that it's not particularly risky to do so.
With foreign stocks, many of which have performed spectacularly over the last few years, the prevailing argument appeals to our sense of conservatism. It's O.K. to load up on international equities, the argument goes, because foreign holdings help diversify our investments. And what could be safer than a well-diversified portfolio?
Of course, a decade ago, the diversification argument didn't hold much sway. That's when foreign shares were being lapped by domestic blue-chip stocks. But today, it's foreign shares that are outperforming — and it's a whole lot easier to embrace diversification when it means stepping into an asset that's already up more than 30 percent a year for the last three years.
The fact is, most every foreign stock market — from Pakistan to China to the United Kingdom — is trouncing United States equities. And their gains look even better to domestic investors, thanks to the falling dollar. The stock market in Brazil, for instance, is up 35 percent year to date in dollar terms, according to an index compiled by Morgan Stanley Capital International, while Morocco is up 63 percent.
Diversifying overseas can lower the risk in your portfolio over the long term. But "in light of the fact that things have gone up so much in recent years, investors need to be mindful of the short-term risks," said Alec Young, equity market strategist for Standard & Poor's.
The biggest problem, as anyone who invested in technology stocks in the late 1990's will recall, is that investments invariably "revert to the mean." This is a fancy way of saying that stocks that are outperforming today will eventually fall back in line with their historic average gains. But to do so, they need to go through a period of underperformance. "And the markets always have a tendency to overshoot on the downside," said Jeremy Grantham, chairman of the asset management firm Grantham, Mayo, Van Otterloo based in Boston.
Of course, there are ways to mitigate some of these short-term risks. One simple method is to practice dollar-cost averaging, which is something we all do in our 401(k)'s. Instead of investing, say, $20,000 in foreign shares all at once, consider spreading your bets over several months or quarters. This way, you'll never be buying foreign stocks at their absolute peak. And should foreign shares begin to lose some value, you will be buying at ever-lower prices.
"People make the mistake of adjusting their allocations in one great swoop," said Sarah H. Ketterer, chief executive officer and portfolio manager with Causeway Capital Management, based in Los Angeles. "But if you're moving from a 100-percent domestic position and cutting 30 percent of that in a single day, it can be quite abrupt."
This is particularly true if you're shifting a sizable portion of your assets from, say, domestic blue-chip stocks to emerging-market equities, which are among the most volatile investments around.
Mr. Young said that given the run-up in foreign stocks over the last four years, investors who were increasing their foreign exposure should look for short-term pullbacks — say a drop of 5 percent or more — in the foreign markets. "Just be patient," he said, and buy on the dips.
Moreover, if you are committing to the foreign markets for the long term, remember to take some profit off the table as you go. That means you have to be willing to rebalance your portfolio not just between domestic and foreign shares, but among different types of foreign holdings.
For instance, say you started out in January 2002 with a portfolio consisting of the following: 60 percent domestic blue-chip stocks, 30 percent blue-chip stocks based in Western Europe and Japan, and 10 percent emerging-markets shares.
By the end of the first quarter of 2006, that portfolio would have become predominantly foreign had you failed to periodically reset your mix of domestic and foreign shares.
But just as important, within your foreign mix, your allocation to the emerging markets would have grown substantially. In this example, you would have started out with 25 percent of your foreign holdings in the emerging-markets equities. But by the end of the first quarter, that allocation would have jumped to 35 percent, far more than many financial planners advise.
Jeff Mortimer, head of equity portfolio management at Charles Schwab Investment Management, said investors should probably keep around 5 percent of their equity holdings in emerging-market stocks, with a total of 25 percent of their equity holdings in foreign shares. However, "if you get too far away from your strategic mix, all of a sudden, you're going to be in an entirely different risk spectrum," Mr. Mortimer warned.
This means it's vital that investors know what they own. According to the fund tracker Lipper, more than 7 percent of the assets in an average domestic stock fund are invested overseas. So if you own a broad-based domestic equity portfolio, chances are that you have substantial foreign exposure already.
Moreover, around 20 percent of the assets in the average international stock fund are in emerging markets, according to Lipper. So it's possible that you already have more-than-adequate emerging-markets exposure without purchasing a separate emerging-markets portfolio.
There are other things that risk-minded foreign investors might want to consider. For instance, stick with funds that are themselves well diversified, said Peter Hill, chief investment officer for the asset management firm Bailard, based in Foster City, Calif.
According to the fund tracker Morningstar, the average international stock fund owns shares in 177 companies. Those funds that concentrate their bets on fewer names sported a standard deviation — a key gauge of volatility — of 17.1 over the last five years. But funds that own more than 200 stocks are far less volatile, with a standard deviation of just 14.6. Finally, risk-minded investors in foreign markets should probably emphasize blue-chip foreign equities.
AS in the United States, small-capitalization stocks overseas have been the market's real darlings. The average foreign growth fund that focuses on small and midcap stocks, for instance, has soared nearly 40 percent a year for the last three years, according to Morningstar. By comparison, foreign large-cap growth funds are up around 27 percent annually.
But after such a huge run-up, Thomas Melendez, portfolio manager with MFS Investment Management in Boston, says foreign small caps aren't as attractive from a valuation standpoint.
This is in part why the MFS Research International fund, which invests in the "best ideas" of MFS's analysts, is 75 percent in foreign large-cap stocks today. Historically, this fund has held around 60 percent of its assets in large-cap names, Mr. Melendez said.
But this doesn't mean investors should avoid small caps — or the emerging markets — altogether.
Remember, if you're moving a portion of your portfolio overseas for the long term, it's all about diversification. And that means being disciplined enough to stick with your asset allocation strategy through thick and thin.
The good news is that over long periods of time, there's usually more thick than thin when it comes to equities. |
