Despite currency risk, international funds can enhance a stock portfolio


If you're planning a vacation abroad this summer, you'll be happy that the U.S. dollar has recently become a bit stronger against other currencies, enabling you to get more for your money.

But if you're in a mutual fund that's exclusively or primarily invested in foreign stocks, you probably weren't thrilled to watch its performance as the U.S. stock market was surging ahead.

Nevertheless, whether the greenback continues its rise or slides back, this may be a good time to consider a top international fund if you're not already in one -- and if you have core positions in one or two U.S. stock funds.

International stock funds invest mainly in securities whose primary trading markets are outside the United States. Holdings usually are diversified among stocks of companies from several countries.

They differ from global funds, which, as classified by Lipper Analytical Services, may own U.S. stocks and need only to have 25 percent of their holdings traded outside the United States. They also differ from funds concentrated in a single region or country.

International funds carry the usual market, industry and company risks that are associated with stock funds. They also, because of their concentration in non-dollar securities, carry currency risk: the possibility that their share prices will fall when the dollar rises in value against other currencies.

Given all these risks, why invest in one? To try to enhance your stock portfolio's rate of return and moderate its volatility.

The U.S. market accounted for around one-fourth of the more than $8.8 trillion in shares in the world's stock markets at the end of June, according to Morgan Stanley Capital International. The overwhelming majority of shares are traded in other markets, any of which can outperform the U.S. market at one time or another.

In the six months ended June 30, the U.S. market had a total return of 14 percent, according to MSCI. But even more dazzling results were reported from the Pacific: Hong Kong, up 27 percent, and Australia, up 22.7 percent. And because the value of currencies did not change significantly against the dollar during the period, the results were virtually the same after adjusting for exchange rates: Hong Kong was up 27.5 percent, and Australia was up 22.1 percent.

Elsewhere, however, the strong U.S. dollar turned outstanding foreign currency returns into disappointment for U.S. investors. Sweden's 36.6 percent gain, for instance, became 1.8 percent, and Spain's 26.6 percent became 6.6 percent.

But don't let such dramatic examples of currency effects make you jittery about investing in an international fund. Remember that volatility attributable to currency risk has its greatest impact in the short term. The effects fade in time.

The point is illustrated by a T. Rowe Price study of the record of its $1.3 billion International Stock Fund, the largest (by a hair over American Funds' EuroPacific Growth Fund) among the international funds.

The fund's securities had positive total returns in foreign currencies -- from 15.6 percent to 0.9 percent -- in 37 of 43 calendar quarters. Even though changes in currency values had a negative effect in half of the quarterly periods, returns for all but three of the quarters were positive after being translated into U.S. dollars. For the entire period, the average annual rate of total return in foreign currencies was 14.5 percent. The impact of currency translation was small and positive: 1.6 percent, lifting the fund's rate of return in U.S. dollars to 16.4 percent.

Leadership among international funds has rotated from year to year, as has leadership among markets. So, you'll want to screen several funds with above-average long-run records to find one that you'd want to trust with your money for several years.

You'll find that they use different strategies. Some, such as Templeton Foreign Fund and EuroPacific, are less volatile than others, partly due to their cash positions of around 20 percent. Others hold less than 5 percent in

cash. Some use a bottom-up approach, seeking undervalued stocks. Others follow a top-down strategy, first looking at economies, then searching for the most promising stocks.

A common step in their portfolio management is to look at the relative weight each national market's capitalization is given in Morgan Stanley's Europe, Australia & Far East Index (EAFE).

Then, after analyzing each economy's prospects, they determine what proportion of that country's stocks should be included in the portfolio.

Increasingly, funds have been going beyond the EAFE universe and adding countries such as Mexico. In fact, Telefonos de Mexico is the lead

ing stock in several funds' portfolios.

"It's an excellent growth play," says George Murnaghan, Price vice president. "If everybody owns it, though, who's left to buy it if we should ever want to sell?"

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