Foreign stocks have trailed the red-hot U.S. market recently but that hasn’t been the case for longer-term investors. For the past 10 years, through April 2013, international stock funds have topped domestic equity funds: Morningstar put the average annualized return for foreign funds at 10.19%, vs. 8.66% for funds investing domestically.
Drilling down, many of the top-performing fund categories were focused on specific areas of the world. Latin American stock funds returned an average of 18.73% a year for the past decade, followed by India Equity (17.56%), Diversified Emerging Markets (15.15%), Pacific/Asia ex Japan (15.07%), Equity Energy (13.24%) and China Region (13.04%) funds. Considering the recent success of several regional and single-country categories, is there a case for holding such high-potential funds in clients’ portfolios?
“I certainly would not recommend regional funds (or any investment) based on strong historical performance,” said Patricia Oey, senior analyst for passive fund research at Morningstar. “Regional funds are more diversified and less volatile than single-country funds, so I would recommend the former over the latter.”
As Oey explained, single-country funds are not only more volatile than their geographically diversified peers, they are often highly concentrated. “For example,” she pointed out, “iShares MSCI South Korea Index Fund’s top holding is Samsung, which accounts for 23% of the fund. As another example, iShares MSCI Hong Kong Index Fund has a 61% exposure to the financial sector. Single-country investing is best left to those with a very strong conviction about the future performance of a single country, or tactical investors who frequently monitor their investments. For most investors, we recommend holding a geographically diversified fund for international equity exposure.”
Indeed, many advisors prefer to invest in broad-based international funds. If those funds are actively managed, the portfolio manager can decide which regions and which companies have the best prospects. Nevertheless, some advisors see reasons for including focused funds for foreign equities.
“It depends on whether or not you look at the world outside the U.S. as one big place,” said Ben Tobias of Tobias Financial Advisors in Plantation, Florida. “Using regional funds, I can overweight or underweight areas I think will do better than others, going forward. I consider that to be the same type of decision-making people do within the U.S. market, choosing between large-caps and small-caps or between growth and value stocks.”
Tobias said that he does not use country-specific funds but does use some regional funds such as Vanguard European Stock Index Fund, iShares S&P Europe 350 Index Fund, iShares MSCI Pacific ex-Japan Index Fund, and Matthews Pacific Tiger Fund. “Most of our clients, except those who are extremely conservative, use them in different proportions depending upon their level of risk tolerance,” he said. Tobias has not used the European regionals for a while but does use the Asian funds.
Clients primarily use broad-based funds for foreign equity exposure, according to Tobias. If a client has 30% of equities outside the U.S., for instance, 20%-25% might be in such a fund while the other 5%-10% may go into regional funds and emerging markets. “Devoting a few percentage points to a region that I like may turn out to be worthwhile,” he said.

Donald Jay Korn

Donald Jay Korn is a New York-based financial writer who contributes to Financial Planning and On Wall Street.