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.

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.”

Among Outlaw’s clients are Karen and Keith Compton of Glendale, California, who invest in Oppenheimer Global Fund. “We want to be well-diversified, and international investments should be included,” says Karen, 40, director of business development at a local architectural firm. “Besides, our global fund has done well.” Indeed, Oppenheimer Global, whose biggest holdings are large companies in the United Kingdom and Western Europe, returned nearly 14% in 2005 and almost 25% per year for the past three years.

This fund, though, is only one of a half dozen funds now owned by the Comptons. “We started to invest with Joe back in the early 1990s,” says Keith, 41, chief finance and administration analyst for Los Angeles County. “Our goals then were to pay off our college loans, pay for our wedding, and buy a home. Thanks to our mutual fund investments, we have met all of those goals and far exceeded what we had hoped to accomplish.”

ALL IN THE FAMILY
The Comptons’ fund lineup now includes other Oppenheimer funds such as: Discovery (which holds small-company stocks), Main Street (large companies), Quest Balanced (bonds and stocks of large companies), Small- and Mid-Cap Value, and Strategic Income (various types of bonds).

“Joe recommended a few fund families, and we did our own research,” says Karen. “We’ve decided to use Oppenheimer because the company’s funds have been consistent performers.”

Outlaw generally recommends Oppenheimer, Putnam, or American Funds to his clients. “If you’re in those families,” he says, “you can change from one fund to another without having to pay a sales charge.” (There may be taxable gains, though.) In some cases, changing mutual funds makes sense or provides comfort to investors.

“I’m a conservative investor,” says Karen. “When the stock market went down sharply after the Internet bubble burst, I wanted to have everything in bond funds.” Outlaw says he recommended the Comptons keep about 30% of their portfolio in stock funds, rather than leave the market entirely.

“A couple of years ago, the market began to improve, so we started to move their money back into stocks. Now they have about 70%
in stock funds,” Outlaw says. “We’ll probably stay around that percentage, investing most of their money in stock funds, because this year should be a good year for equities.”

WHERE THE VALUES ARE
That’s not to say that Outlaw is bullish on all segments of the stock market. “I pulled my own money out of Oppenheimer Real Asset Fund,” he says. “And I’m advising clients who own the fund to do the same. That fund does well when the price of oil goes up but I think we’ve gotten all the mileage we can from oil price increases.”

Clients in other fund families may try moving out of oil-heavy funds into foreign favorites such as Putnam Voyager, which “has been picking up lately,” says Outlaw, and American Funds’ EuroPacific Growth, which is a “tremendous fund.” EuroPacific, too, has returned more than 24% a year for the last three years.

Outlaw is also upbeat about domestic stocks this year. “Once Ben Bernanke replaces Alan Greenspan as head of the Federal Reserve, interest rates probably will level off,” he says. “That will be a big help for U.S. stocks; small-cap and value funds, which have led recently, still look good, while a lot of technology companies may do well. I also continue to like real estate; the next time I meet with the Comptons, I may suggest they invest 5% to 10% of their portfolio in a real estate fund.”

No matter which funds the Comptons choose, based on Outlaw’s suggestions and their own research, they plan to invest regularly. “For years,” says Keith, “we’ve arranged for automatic investments from our bank account to our mutual funds. That way we don’t think the money is ours to spend.” Such periodic investing, known as dollar-cost averaging, is a proven way to build up fund holdings over the long term at a reduced per-share cost.

In fact, the Comptons are so enthusiastic about mutual fund investing that they’ve already opened up tax-advantaged 529 accounts for both of their young children. “Oppenheimer has a Scholar’s Edge plan we like,” says Karen. “Our children have so many years until college that we can invest aggressively, seeking high returns. Spreading the money around five different funds helps to reduce risk.”

STARTING FROM SCRATCH
Sometimes, though, risks are worth taking. Just ask Rosemary Speed, 46, a customer service representative at a federal agency in Buffalo, New York. “I had been playing the lottery for about eight years,” she recalls. “Then, in 2003, I won first prize — $1 million.”

Winning $1 million in New York’s lottery is not like receiving 10,000 $100 bills one day. “I was going to receive $50,000 per year,” says Speed. “After tax, that would have been around $33,000.” New York law permits lottery winners to sell their future income stream to a third party, which is what Speed did, pocketing $520,000 pre-tax.

“I used some of that money to buy a house,” says Speed. “The rest I’ve invested, mainly in mutual funds. My goal is to have enough money for a comfortable retirement, around age 60.”

Speed’s five mutual funds combine to form a well-balanced portfolio. “Diversification is always the No. 1 thing we look for when tailoring a selection of mutual funds for a client,” says Deborah Jordan, a financial planner with Ameriprise Financial in Williamsville, New York, who advises Speed. “We usually include international exposure because of the opportunity for enhanced returns and the diversification benefits of investing in foreign stocks.”

In particular, Jordan has suggested that Speed invest in Templeton Foreign fund, which holds large companies based in Japan, Hong Kong, and Europe. “This is a tried-and-true fund with a long, established track record,” she says. “The managers don’t do anything exotic, but they produce steady returns for investors.”

The other funds in Speed’s portfolio are also proven entities. She holds George Putnam Fund of Boston, a balanced fund that owns big-name stocks such as ExxonMobil and Citigroup along with high-quality bonds. “This fund has been a strong performer since 1937,” says Jordan, “so we’re confident it will continue to do well.”

Among Speed’s other holdings is Eaton-Vance Tax-Managed Dividend Income Fund. As the name suggests, this fund invests in stocks such as Marathon Oil and Bank of America that pay hefty dividends. At press time, its yield was nearly 5%, greater than the yield on Treasury bonds. What’s more, the fund is “tax-managed,” meaning that its managers employ tactics designed to reduce taxable distributions to shareholders.

“For additional tax-efficiency,” says Jordan, “we invest in Eaton Vance New York Municipals Fund.” As is the case with all municipal bond funds, it delivers income that’s exempt from federal income tax. This fund, moreover, holds only New York issues so the bond interest is exempt from state income tax as well.

The final ingredient in Speed’s blended portfolio is Evergreen Special Values. “This fund looks for small, undervalued companies,” says Jordan, “and it is another excellent long-term performer.” Through 2005, it had returned more than 15% a year for the previous 10 years.

No one fund, or even a variety of funds, can guarantee such impressive long-term results. The best strategy is to hold a diversified portfolio, making sure to include some foreign stock funds in the mix. Investors who hold solid funds in different categories may well be smiling at the end of 2006, no matter what this year might bring.

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