Your Money : Foreign Investment Not Always Diversification

For years, one of the standard arguments for buying international mutual funds has been that they provide diversification.

Foreign companies face different economic pressures and opportunities compared to their American rivals, so it’s natural to expect that their stock prices would behave in different ways.

Divergent movements are actually desirable, the diversification pitch goes, because they help pave the way to a smoother ride overall. When your U.S. stocks or stock funds are falling, your foreign holdings could be rising, and vice versa.

But the diversification argument has been called into question lately, after a year in which foreign equity funds dropped in step with their American counterparts.

“The old argument that international funds give investors diversification in terms of market direction no longer applies,” said Michael Lipper of Lipper Analytical Services, a fund-monitoring firm in Summit, N.J.

“Both securities and world economies are becoming more closely linked to (those in the United States), and you won’t see the world moving in a different direction from this country,” he reasons.

As a source of particular frustration, foreign markets don’t seem to deliver much relief when investors need it most--that is, when American stock prices are heading south.

Last year, for example, general U.S. stock funds slumped 1.69% on average, according to Lipper Analytical, and broadly defined international portfolios slipped 0.71%.

In 1990, another down year, U.S. stock funds dropped 6.27%, while international portfolios slid 11.95%.

During the tumultuous fourth quarter of 1987, U.S. stock funds tumbled 20.43% and their foreign cousins lost 17.43%.

Numbers such as these seem to undermine the argument that cross-border investing helps to reduce risk. And as national economies become more and more interconnected, the diversification angle could pale further.

*

Certainly, it’s safe to say that spreading your assets among different countries won’t always provide for a smoother ride overall.

But accepted notions don’t die easily, and the international-diversification idea still has some life in it. In fact, many investment experts say the argument remains intact, provided you see it from the correct point of view.

“The quick answer is that international diversification does work over the long term,” said Derek Sasveld, a consultant at Ibbotson Associates in Chicago.

Brent Lynn, a senior foreign-stock analyst at Janus Funds of Denver, added: “We believe international diversification is very important.”

Here are some pointers for keeping the issue in proper perspective:

* Diversification tends to work better over long periods.

Over the first five years of this decade, U.S. funds outperformed their foreign rivals nearly 2 to 1, but during the last half of the 1980s foreign portfolios fared better than twice as well. Although the two groups moved in the same direction during both periods, they moved up at markedly different paces.

* Some foreign stock markets will almost always perform better than markets in the United States. Last year, for example, Japan, Finland and Norway all logged double-digit advances, Lynn notes. And in 1993, Latin American and East Asian markets were on fire.

Of course, the reverse also holds true. Many foreign bourses will underperform American stocks in any given period. For this reason, it’s wise to spread foreign investments among different nations, even regions, of the world--that is, to diversify.

* The size of foreign stocks owned also can make a difference. Many fund managers buy shares in the most visible and widely traded names in a country, such as Sony, Nestle and Telefonos de Mexico. To the extent a foreign giant has a large U.S. operation or has a lot of shares trading in this country, the stock’s price could move in sync with the American market.

A good test here is to check the top holdings of your international fund. If you recognize most of the names, it may indicate a lessened diversification benefit, says Sasveld.

* Currency rates can be a factor. When the dollar is rising in value, that drags down the performance of foreign funds from the perspective of American shareholders. A declining greenback puts the wind at your back.

Currency fluctuations are an important, even desirable ingredient in the diversification mix, Sasveld says.

For this reason--and because it costs money when portfolio managers try to hedge against currency fluctuations--he recommends that investors stick with unhedged foreign-stock funds.

*

In short, it seems premature to declare the demise of international diversification. But even if you’re not convinced that a modest dose of foreign-stock funds can give you a smoother overall ride, investing overseas still makes sense for another reason. “Over a very long-term horizon, the greatest growth potential exists internationally, especially in the emerging markets,” Lynn explained.

Sasveld suggests placing 25% to 30% of your portfolio in foreign- stock funds, with perhaps a fourth of that amount earmarked for emerging markets.

Even Lipper agrees that foreign holdings make sense, if not for diversification reasons, at least for their “unusual (profit) opportunities.”