Editor's Note

04/26/2007 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

Posted Thursday, April 26, 2007

For the last few weeks, I've looked at why international markets have easily outpaced US stocks so far this decade. Now I'm going to tell you what I think you should do about it.

Developed and emerging overseas stock markets have done about twice as well as the big-cap benchmark Standard & Poor's 500 over the past five years. That has led US investors to rush headlong into funds that track various overseas markets, a trend that may have abated a bit since February's meltdown in Chinese stocks (see "Sell China, Buy American," February 22).

International stocks used to be a small part of US investors' holdings, maybe 5% to 10%, mostly for diversification and risk reduction. 

Because international stocks historically didn't move in tandem with US markets, holding overseas equities could smooth out the bumps in any portfolio, or reduce its overall risk.

As international markets thrived, though, advisors began to see the light-or chase performance. The rise of international investing coincided with an explosion of alternative investing vehicles like hedge funds and giant private equity firms that posted staggering returns for their well-heeled clients over the past few years.

Original thinkers like David Swensen, chief investment officer of Yale University, also turned conventional wisdom on its head and diversified well beyond US stocks and bonds, with spectacular gains.

Now, some advisors, such as Bruce Johnstone, managing director of Fidelity Investments, say investors should put a lot more money overseas. "In my own retirement plan more than half of my equity assets are in non-US equity funds," he said here in 2003. "That's how strongly I believe in this kind of asset allocation."  

You can't argue with the results, but after several years of stellar performance, I think overseas markets are due for a rest, and as I've written here before, I believe US growth stocks will regain their luster.

So, if 5% is too little and 50% is too much, how much should you put in foreign stocks? (And we're talking only about how you divide up your equity holdings, not how much you put in stocks, bonds, cash, etc.)

Brandywine Global Investment Management, a subsidiary of Legg Mason, did an intriguing study called "A Case for International Diversification," which you can find here.

The firm measured the total return and risk of several combinations of the MSCI EAFE index and the S&P 500 over the past ten years. The chart below, reproduced with permission of Legg Mason, illustrates the results:

As you can see, the highest total return came from a stock portfolio that had either 10% or 20% of its holdings in the MSCI EAFE and rest in the S&P. The lowest came from a 100% EAFE portfolio (probably reflecting all those years of underperformance in the 1990s). The riskiest-the portfolio with the most volatility-held only the S&P 500.

(The study did not include emerging markets, which aren't in MSCI EAFE, or small- or mid-cap US stocks, which aren't in the S&P.)

When I look at the chart, the best combination of low risk/high return (the so-called "efficient frontier" of finance theory) seems to be EAFE holdings of 30% or 40%, although there isn't a huge spread among several of the portfolios tested.

There's no magic formula, says Safa Muhtaseb, a Brandywine portfolio manager who worked on the study.

He sees some convergence in performance and profitability of all the developed markets. "My guess is, you're going to get similar returns from [the US, Europe and Asia] over the next few years," he says.

Muhtaseb, a value-oriented manager, says growth stocks may be the "new" value.  "Clearly growth has underperformed value," he observes.

That's why I'd continue to overweight large US growth stocks while cutting back on riskier asset classes, like high-yield bonds, domestic REITs and emerging markets.

Right now I think 40% of investors' equity portfolios should be in large US stocks-30% in an S&P 500 index fund or ETF and the other 10% in a large growth fund (like T. Rowe Price Blue Chip Growth) or ETF, like the iShares S&P 500 Growth index ETF (IVW).

Another 30% should be in a diversified small- and mid-cap fund or ETF. Or you can put 60% of your equity portfolio into a total market fund, like the streetTRACKS Total Market ETF, or TMW, and the other 10% in a large-company growth fund or ETF.

That leaves 30% for international stocks. I'd put 25% of that in a developed markets fund that more or less tracks EAFE and no more than 5% in emerging markets, whose days of outperformance are numbered, I believe.

Or you might put the whole 30% into the new, broadly diversified Vanguard FTSE All-World ex-US Index fund (VFWIX) or its ETF cousin (VEU), which encompasses 47 developed and emerging markets.

One reason you don't have to put so many eggs in the international-stock basket: The big multinationals in the S&P 500 get about a third of their sales from overseas markets (some get more than half), and that helped many companies' earnings top Wall Street's estimates in the first quarter.

So, if you own US blue chips, you may be more of a global investor than you realize. It's a small world.

Comments? Please email us at TopProsTopPicks@intershow.com.

Howard R. Gold is editor-in-chief of MoneyShow.com. The views expressed in this commentary are his own and do not necessarily reflect the opinions of InterShow.


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