Analysis: Are investors going overboard on foreign funds?

WASHINGTON Mon Nov 29, 2010 5:05pm EST

Traders work on the main floor of the BM&F Bovespa stock exchange market in Sao Paulo October 16, 2008. REUTERS/Paulo Whitaker

Traders work on the main floor of the BM&F Bovespa stock exchange market in Sao Paulo October 16, 2008.

Credit: Reuters/Paulo Whitaker

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WASHINGTON (Reuters) - Advisers have been telling U.S. clients for years that they should be internationally diversified, but some experts are now concerned that investors might be taking that advice too far, especially when it comes to mutual funds that focus on developing country stocks.

"There's a risk of going overboard," says Jeff Tjournehoj of Lipper, a mutual fund research firm and Thomson Reuters unit. "The fear is that people start putting money to work after the best money has been made," he said in an interview.

Through November 17 this year, investors have pulled $74 billion out of domestic stock funds and put $41.8 billion into foreign stock funds, Investment Company Institute data shows.

U.S. investors continued to send their money abroad in October, putting $7.23 billion into stock funds that invest primarily overseas, while draining almost that much -- $6.79 billion -- from domestic stock funds, ICI reported.

What's more, the bulk of that money has gone into shares of companies in developing countries. Roughly 97 percent of money flowing into foreign stocks has gone to emerging markets, according to a research paper from Vanguard Investments. Those markets have racked up strong growth for most of the decade, but their most recent performance has been disappointing.

In the last 12 months though November 26, Chinese stocks have fallen 9 percent, Indian stocks have gone up 13 percent and Brazilian stocks have gone up 2 percent. By comparison, the Russell 2000 -- an index of 2,000 small-cap stocks -- rose 23 percent over the same period, Lipper said. "Just by staying home you would have beaten the crowd," said Tjournehoj.

Advisers do recommend that investors keep some of their money invested internationally. The American Association of Individual Investors suggests that aggressive investors keep 20 percent of their portfolios in stocks from developed countries and 10 percent in emerging market stocks. Conservative investors could aim to keep a mere 5 percent in developed country stocks and nothing in emerging market shares.

That's because emerging market shares can be riskier, said Charles Rotblut, a financial analyst and vice president of the AAII, a consumer investment group. It's harder to know what's going on in politically in those nations, and their regulatory and corporate financing systems are developing, too.

"There's the risk of political involvement too, and they are still developing from the standpoint of protecting investors," he said.

U.S. investors may have been enticed by the fast growth of the BRIC countries: Brazil, Russia, India and China, suggested Vanguard. In the 10 years ended August 31, emerging market stocks have risen more than 10 percent a year, while shares of developed country stocks and U.S. stocks have barely budged, or fallen, said Vanguard.

But fast economic growth doesn't necessarily result in exceptional stock returns. "Emerging markets were undervalued... (vis a vis U.S. stocks)... in the early 2000s, whereas they tend to be more similarly valued today," said the authors of the Vanguard research paper, Christopher Philips, Francis Kinniry Jr. and Yan Zilbering. "We therefore would caution investors against pinning too much on a belief that economic growth will propel emerging markets toward future outperformance matching that of the past."

Investors who want to keep part of their money overseas should invest through funds that keep expenses low, says Tjournehoj. Lipper has identified two funds as favorite big, broad international stock funds: the Vanguard FTSE All-World ex-U.S., which has an expense ratio of 0.25 percent, and the Powershares International Dividend Achievers, with an expense ratio of 0.57 percent.

But don't put all of your eggs in that basket, either, says Rotblut. Break it up between developed countries and emerging economies, suggests Rotblut, who said money aimed at illiquid small company shares internationally might benefit from having an active fund manager.

Finally, remember what the money is for. Tjournehoj notes that individuals investing for their retirement should remember that their future expenses are likely to be denominated in dollars, not some foreign currency. "If you keep the bulk here, you won't be left with any surprises" when retirement arrives, he said.

(Editing by Steve Orlofsky)

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