Foreign Powers

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.

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