Should You Join the Rush to International Equities?

American investors are pouring money into international stock funds at a rate that is likely to set a record. Seeking an alternative to less-than-stellar U.S. stock market performance, investors increased their holdings of international mutual fund shares by $56.6 billion during the first nine months of 2004.¹ At that pace, it seemed likely that 2004 inflows would surpass the record $58 billion of new money that flowed into international funds in 1994.²

Looking back over the past year, it’s easy to see the attraction.

The MSCI EAFE Equity Index, a measure of the stock performance of 1,100 companies in 20 countries, mostly in Europe and the Far East, was up 23% for the 12-month period ending September 30, 2004. That’s far ahead of the 14% return from the S&P 500 during the same period.³

Make Sure It Fits

Purchasing shares solely on the basis of an outstanding 12-month return would be considered “performance chasing” — a strategy that many financial professionals consider unsound.

International holdings may be appropriate when they are part of a well-rounded portfolio governed by a long-term plan based on your time horizon, risk tolerance, and personal goals. As with any investment, however, it’s critical to consider the risks before making any decisions.

Currency Risk

The value of an investment denominated in a foreign currency is subject to fluctuations in value between that currency and the dollar. Such investments can lose performance when U.S. investors reconvert from a foreign denomination that is declining against the dollar. Recently, however, the dollar has been on a downward trend after years of record strength, which may be another reason for the rush to invest abroad.

Political Risk

A 2004 study published by the Federal Reserve Bank of St. Louis noted that societies that have a well-developed legal system that enforces contract rights, preserves property rights, and provides other essential economic protections tend to experience greater economic growth.⁴ Although these protections are often taken for granted in the United States, it’s important to be cautious about the situation under some foreign governments.

Correlation Risk

A well-allocated portfolio will include asset classes that have a low correlation. That is, when one class performs poorly, it will be offset by another class that performs well. Historically, there has been low correlation between the international and domestic markets, although some experts believe this is changing.5 Because the U.S. economy is the world’s largest, the rest of the world is increasingly affected by its ups and downs. The large amount of money that is rapidly flowing into international investments is a positive indication — but it’s hardly a sure thing. Any decision to participate — or increase ownership — in international equities should be made only after a thorough review of your personal circumstances.

1, 2, 5) Investment News, October 18, 2004
3) Thomson Financial, 2004. U.S. stocks are represented by the S&P 500 Composite Index total return index, which is generally considered representative of the U.S. stock market. Foreign stocks are represented by the MSCI EAFE Index, which represents the stock markets in Europe, Australia, and the Far East. The performance of an index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results
4) Federal Reserve Bank of St. Louis, 2004

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