Mutual Funds Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
March 2010

What in the World Is an Investor to Do?

By Tom Madell, PhD

There are currently a great many uncertainties for anyone attempting to judge the prospects for funds invested abroad. In this article, I will briefly discuss some of the issues involved and offer arguments as to whether one should either raise or lower one's international investments.

During most of 2009, continuing through the start of this year, data show that investors have been putting the lion's share of their new stock fund investments into international, and especially, emerging market funds (hereafter abbreviated EM). In fact, while a record amount of money went into EM funds in 2009, at the same time, US investors were withdrawing money from domestic stock funds.

As a result, and assisted by some outperformance by international funds over the last year, we estimate that investors have bumped up their non-US allocations to at least 25-30% of their total stock allocations, on average. As of just a few years ago, this percentage was more like a mere 15% or so. One of the first questions to be addressed, then, is whether these increased allocations are a wise thing.

On the whole, an allocation within this bumped up range does seem appropriate for reasons that will be spelled out in a minute. In arriving at your percentage allocated internationally, one must not forget to factor in the fact that many managed domestic funds, included sector focused funds, may already have a moderate degree of international exposure. For example, the popular Fidelity Contra Fund is about 20% invested abroad while Vanguard Energy is about 40%. Therefore, if your domestic funds already average, for example, about 20% invested abroad, having another 25% allocated to an international fund would put your portfolio at 40% abroad (eg, 75% of your stock portfolio x .20 = .15 abroad plus .25 = .40 or 40%). Of course, most domestic index funds would have no foreign exposure.

While having an allocation higher than 25-30% may at times be very reasonable, there are many factors going on now which lead me to urge caution if you are already higher, or considering making such a move. As with most investing decisions, there are both positive and negative arguments for each approach.

Right now, we do not think it particularly wise to concentrate too much (or totally avoid) any one category of investment, whether it be in your allocations to stocks vs. bonds, domestic vs. international, or especially, within the EM category. This would be true, we feel, unless you are sure that you have a high risk tolerance. Concentration of assets into any one investment category is almost always the reason for investing disasters.

Although emerging markets are currently the top-rated category among many experts, and have hugely outperformed US investments over the last 10 years, we do NOT recommend putting any more than about 10 to 20% of your total stock investments in EM at this time. Thus, we certainly diverge from what appears to be the current consensus by recommending particular caution with regard to EM investments.

As with domestic vs. international overlapping, one needs to be aware of any amounts invested in "ordinary" international funds that are actually invested in EMs. For example, if you own Vanguard International Growth, it currently is 20% invested in EM as reported on Vanguard's website. This means if this fund represents 25% of your stock fund allocation, you already own 5% in EMs (eg, 25% of your stock portfolio x .20 = .05 or 5%). Any additional investment in a fund that is specifically dedicated to EMs would need to be added to this amount in determining your EM allocation.

It may not always be clear how much of a given international fund is invested in emerging markets. While not labeled as such, a fund may actually be substantially similar to an EM fund. Take, for example, the Janus Overseas Fund. This fund (recommended at times in our Newsletters) has been a great long-term performer, especially over the last 5 years or so. (An exception was during 2008, a bear market year, when it performed very poorly.) Information on the website would suggest the fund is only currently about 24% invested in EM's such as Brazil, India, Hong Kong, and the Philippines. Yet, over the last five years, it has shown a near perfect correlation with a fund which is 100% invested in EM, namely the Vanguard Emerging Markets Index.

Fund managers often try to outperform their competition by investing in highly risky stocks which they hope will show the highest returns. When these stocks are performing well, the returns are likely to be market-beating. But when a downturn hits, these funds can wallop you with bigger than average losses as happened in 2008.

Here is a quick way to determine if an international fund you are in, or considering buying, is similar to a "pure" EM fund: Click on the following link to to see the nearly identical performance of of Janus Overseas with EM performance:
                                                    ^^^^^ (replace JAOSX with your fund symbol - eg JAOSX is the symbol for the Janus Overseas Fund; VEIEX is the symbol for the Vanguard Emerging Market Index. If the two 5 yr. performance graphs' ups and downs shown are close to the same height, the funds are acting identically. Most international funds should not have gone up and down as much as a pure EM fund.)

EM funds have had a great run since the end of the global bear market last March, with a typical fund up approaching 90%. On the other hand, one might argue such funds are still down more than 30% cumulatively since the start of the global downdraft in Oct. 2007. Therefore, since nearly all world economies, especially the EMs, seem to be in recovery mode, perhaps it is not unreasonable to expect these funds will continue to make up for their previous loses.

The rationale given by experts for choosing a relatively high exposure to EMs is that they are generally showing much higher growth rates than in most of the developed world, fed by exporting prowess and an ever-increasing percent of their populations acquiring the means to enter the "consumer class." As valid as these arguments may seem, good growth rates and high levels of consumption do not necessarily translate in good stock market performance. This can be illustrated by looking no further than in the US during the last decade.

Many of these growth arguments may already be reflected in stock prices, with investors who are sold on the category having already piled in. In fact, over the last 6 months, as contrasted to over the entire past year where EMs outperformed the S&P 500 by about double, the outperformance has been reduced to just a few percent, with actual underperformance in the last 3 months.

The bottom line for EMs is that while the category does not appear to be dangerously overvalued, it could disappoint and not outperform the remainder of your international or US investments in the years ahead.

We suggest you might want to think of EM funds as similar to other international funds, only "on steriods." If the US market continues to do well, so will international funds in general, with EM leading the pack. But if the US falters, the order could well be reversed with EM magnifying whatever drop is shown in the US. (Even though, historically, the long-term correlation between EMs and the S&P 500 Index has shown to be only slightly positive, ever since the start of the '03 bull market, EMs have basically doubled whatever gains or losses US stocks were showing.)

This brings us to a discussion of what the prospects are for the remainder of your international stock funds that are not in the EMs. In particular, with all the focus recently on debt problems within Europe, and given that most "plain vanilla" international funds are often invested there more than any other region, one might ask is it wise for so many investors to be increasingly invested there?

In addition to worries about how Europe will deal with government debt issues, there is a huge uncertainty as to where the European common currency, the euro, might be headed. When the euro is strong and the dollar weak, as it was for most of 2009, this is a big plus for US investors in international funds. However, when the euro is weak, US investors find that their returns are pulled down, even if European stock markets themselves might be doing OK. In other words, it is important to have a sense of where the dollar might be headed over the next few years when allocating to international funds.

Over the last nearly 10 years, the euro has been mainly trending stronger against the dollar, with the currency gaining over 60% vs. the dollar. This helps to explain why international stock funds have outperformed US funds over the decade. For example, if you invested in a European stock index fund such as Vanguard Europe (VEURX), you would have done considerably better than European stocks themselves actually performed in their local markets. This is due to adding one's gains made as you "held" euros which became more valuable.

This created the following paradox: Since early 2003, while an index of the 50 largest European stocks, the DJ EURO STOXX 50, was down approximately 15%, VEURX was up about 25%! Success for US investors was not based, then, on good stock performance, but rather, the favorable returns generated by the weaker dollar. Similarly over the same period, VEURX did better than the Vanguard 500 Index (VFINX), even though large US stocks did better than the large European stocks.

Since reaching a peak this past November, however, the euro has been falling, about 10% thus far. If this were to become the new trend, it would mean that one might expect international funds to do more poorly than otherwise would be the case. In fact, since the euro started sliding, while DJ EURO STOXX 50 was recently down about 3%, VEURX was down about 12%. This 9% worse performance reflected the negative effect of the strengthening dollar for US investors. At the same time, as compared to the S&P 500 Index, VEURX was down by 10% more (-2% vs. -12%). Clearly, there is a lot more to international investing than just appraising likely stock prospects for regions abroad; a large gain or loss in the value of the dollar can drastically affect your results.

Given the high volatility of both the international stock markets and currency markets during the current extreme economic uncertainty, this explains why we are recommending an maximum allocation of only around 25-30% for most investors, unless of course, you are able to tolerate a high degree of risk in the hopes of maximizing gains. Whatever losses are possible in the US markets, such potential losses can be compounded when investing internationally. In other words, it is more important than ever not to invest in foreign countries solely because the last decade's returns were better than those in the US market.

Unfortunately, we believe that trying to predict the short-term direction of the US dollar is nearly impossible. And the accuracy of predictions of its longer-term direction aren't likely to be much more precise than a coin toss either. However, if one would like to get a better sense of its future direction, we believe that a continuation of the on-going long-term trend is often the best guide, unless there are clear reasons that the fundamentals causing the trend have changed significantly. And on this score, the reasons for the dollar's fall during the last 10 years, which are discussed next, appear likely to remain intact. Therefore, we believe that the dollar is more likely to merely rise in the short term, and eventually, to continue its multi-year downward trend.

One of the reasons the dollar is now rising is that, compared to Europe, the US is seen as having better growth prospects and is more likely to raise interest rates this year. The European debt crisis has added to the view that Europe, and the euro, will be weak. But, to us, current evidence suggests that neither US growth going forward, nor gains in employment nor housing, will be sufficient to convince the Fed to raise rates until early next year, at the earliest. We further believe that the eurozone authorities, or one or more individual European countries, will help prevent a potential "euro-busting" crisis in Greece, and elsewhere such as in Spain. There has simply been too much effort and ideology expended in creating the eurozone to allow potentially solvable problems to be left unchecked, almost no matter what the short-term cost.

If so, before long, the reasons for a weak dollar that prevailed for the last decade will probably return to focus. After all, the US itself has huge and mounting government debt (see Steve's article) which will be difficult to reverse under even ideal circumstances. Political gridlock seems likely to make any real progress even more difficult to obtain.

Until the US acts to significantly convince the markets it will reduce its deficits, it seems plausible that foreign investors, having already seen the value of their US investments fall due to currency losses, may become ever more likely to reduce their US dollar holdings. After all, foreign investors lose money on their US investments when the dollar drops, just the reverse as for US investors. This would result in a furthering of dollar weakness.

All this suggests that US investors may want to wait before considering boosting allocations to international funds for now, and may even want to consider reducing them, especially if already above the 25-30% range. But if dollar weakness returns, the wind would once again be at a US investor's back, justifying a greater allocation. The same can be said for investments in international bond funds.