Foreign powers: with many investors anticipating an off year for the market, where can you find funds that will beat expectations?

Black Enterprise, April, 2006 by Donald Jay Korn

FOR MANY MUTUAL FUND INVESTORS, 2005 WAS A disappointing year. Domestic stock funds gained less than 7% on average, according to Chicago-based Morningstar Inc., while bond funds returned about 2%. Both categories wound up far below their long-term annualized results.

Investors with broader horizons, though, had reason to celebrate, as virtually every type of foreign stock fund posted solid gains:

* The average international stock fund gained 17.39%.

* The farther you ventured from familiar paths, the better. Funds that invested in so-called "emerging markets" (developing nations) returned 31.61%, while one subcategory--Latin American funds--posted a torrid 53.43% gain.

* Asian funds were robust, too, with Japanese entries up 32.86%.

* Although European funds lagged behind their Asian competitors, they still returned 13.25%--more than double the results of U.S. stock funds.

Will foreign stocks continue to rule the world in 2006? "It's hard to tell whether international stock funds will have another good year," says John Coumarianos, an analyst at Morningstar. "We are pleased to see U.S. investors increasing their exposure to foreign stocks because there probably will be long-term advantages. On the other hand, we fear there might be a lot of performance chasing now. Investors are going into international stock funds because recent returns have been so strong. An asset class that has had a strong run may not continue to be a leader."

Regardless of the near-term outlook, investors generally should include some international funds in their portfolios. Over decades, according to Coumarianos, a global group of funds may deliver superior results with less risk, compared with a domestic portfolio.

OFFSHORE ON THE RISE

Why were non-U.S. stocks the big winners last year? "To some degree, the outperformance of foreign stocks in 2005 was a valuation story," says Brian Gendreau, investment strategist for ING Investment Management in New York. That is, companies outside the U.S. looked less expensive than domestic companies when comparing stock prices to corporate earnings.

As the year went on, though, foreign stock prices rose faster than U.S. stock prices so the valuations converged, reducing the appeal of foreign stocks. "Then there was a pickup in growth in Europe and Japan at year-end, which helped those stocks," says Gendreau. "Also, companies in Europe and Japan appear to be restructuring with some success." Some Western European companies, for example, are outsourcing labor to Eastern Europe, reducing costs and thus boosting profits--a process investors find appealing. With such developments, the run-up in international stock funds "may have more legs," according to Gendreau.

As for emerging markets, Asian funds won favor in part because of the growth prospects of countries such as China and India, while Latin American funds benefited from interest in energy and telecommunications. "A lot of people in Latin America are using cell phones, even when there are no land lines, and that has helped telecom companies there," says Coumarianos. In addition, both Brazil and Mexico have substantial oil resources, which attracted investors to those economies in 2005. Ongoing cell phone demand and continued strength in oil prices could extend the strong performance of emerging market funds.

HEADING FOR HOME?

Domestic markets are also difficult to forecast. "For several years, small-cap and value funds have led the way," Coumarianos says. Value funds seek undervalued stocks, compared with growth funds, which attempt to invest in companies where earnings are growing rapidly.

Last year, Coumarianos says, leadership rotated to mid-caps--those companies in between the biggest and smallest players. Mid-cap growth, blend (growth and value combinations), and value funds returned 9.64%, 9.22%, and 8.36%, respectively, in 2005, which were the best results of all diversified U.S. fund categories.

"Toward the end of the year, large-cap growth funds were very strong," Coumarianos says. "It's possible this trend will continue and large-growth will have excellent results in 2006."

Similarly, Gendreau is encouraged by the prospects of the large-cap U.S. issues that have lagged since 2000. "Earnings recently have been strong for major corporations, yet the markets have not reacted," he says. "Therefore, valuations for large-cap stocks, especially growth stocks, have become more attractive."

What might make markets react to the improved prospects of large-cap growth funds? "The catalyst could be a sign that the Federal Reserve has stopped raising interest rates. Such a move would be like a Good Housekeeping Seal of Approval for the economy, indicating there's little danger of inflation in the near term," says Gendreau. "Four of the last five times that the Fed stopped tightening, U.S. equity markets went up sharply."

TOO MUCH OF A GOOD THING

What portion of your mutual fund dollars should you ship outside the country? Although some investment pros recommend steep allocations, Joe Outlaw, president of PenTrust Financial Services in San Diego, does not want to go overboard overseas. "I think 20% of your portfolio is enough," he says. "International funds are doing well, so we're moving clients' money there if they have too little in foreign stocks. There may be more opportunity outside the U.S. now. Still, we don't like clients to have too much of their money in one category because you don't know what will happen from one year to the next."