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Great Expectations: What Popular Foreign Funds May Be In For

Investors have flocked to international funds, but have they made good choices?

Bridget B. Hughes, 11/20/2006

Just five years ago, some may have questioned the utility of international funds. After all, U.S. stock funds were soaring to the top of the performance charts in the late 1990s. Then when markets came tumbling down in 2000, international offerings didn't provide all that much ballast. In the relative calm of the past few years, though, many international funds have proved their value, and investors have noticed.

Recent fund flow data, provided by Financial Research Corporation, or FRC, show that investors have been loading up on international funds. As of the end of September 2006, FRC estimates that "International/Global" funds now compose fully 20% of mutual fund assets. Although global funds include U.S. stocks and investors certainly have investments other than mutual funds in their portfolios, it indicates that foreign investments have become a bigger piece of investor portfolios than they have been.

The increase is simple mathematics. First, international funds have performed quite well compared with U.S. stock funds. Over the past one- and three-year periods, every foreign-stock category (with the exception of Japan-stock) has outdone every diversified U.S. stock grouping. Second, investors have been buying foreign offerings in recent years. For 2006 through September, the three largest foreign categories, foreign large-value, foreign large-blend, and foreign large-growth, together took in nearly $70 billion--close to 40% of total year-to-date flows into all mutual funds.

While we're happy to see investors paying more attention to foreign funds, we hope that the motivation behind the interest isn't based on recent performance alone. In fact, we'd encourage investors to temper their expectations of these funds, considering international funds' strength over the past several years relative to U.S. funds. We also encourage investors to be tolerant of any near-term weakness.

Having said that, every fund is different, with its own set of considerations. Below we offer our thoughts on the year's most popular foreign-stock funds. They are listed in order of how much money they've consumed so far this year and represent all nine of the international funds that made FRC's list of the 20 best-selling funds through September 2006.

American Funds Capital World Growth & Income CWGIX
In 2006, this fund has taken in close to $12 billion, bringing its total assets to more than $75 billion currently. Fortunately, the fund's world-stock mandate, which allows it to buy stocks from anywhere around the world, gives it a large investment universe. But we're growing concerned about its size, which could make it tougher to maneuver in order to weather various market conditions--something that the management team has been able to do quite well here. Nonetheless, its broad investment mandate, long-term approach, and superb research and management capabilities give us confidence in this fund over the long haul. It's quite reasonably priced, too.

Bottom Line: A solid pick.

American Funds EuroPacific Growth AEPGX
Like its sibling discussed above, this offering is cheap and boasts the same type of impressive research and portfolio-management backbone. Certainly, its shareholders have been well served. We are more concerned about this foreign large-blend fund's size than we are with Capital World Growth & Income's, however. Its mandate limits its investment universe to just non-U.S. stocks, roughly cutting its opportunities to half that of its world-stock counterpart. Further, its tendency to invest a decent chunk of its portfolio in emerging-markets stocks could hinder it; those markets tend to be less-liquid and more-volatile. That said, it remains a very solid core international offering.

Bottom Line: A good long-term core holding.

Dodge & Cox International Stock DODFX
This foreign large-value fund seems to have everything going for it. It is cheap, it has a great research team, and its performance has been topnotch. Yes, it's getting big, with more than $25 billion in assets, but its long-term, value-oriented approach is well suited to handle a large asset base. Further, Dodge & Cox has shown it's prepared to close a fund when appropriate. In fact, two of Dodge & Cox's four funds are already closed.

Bottom Line: Get in while you can. Dodge & Cox has been proactive about closing its funds.PAGEBREAK

American Funds Capital Income Builder CAIBX
This is our favorite world-allocation fund. With $77 billion in assets, it's huge. However, its investment mandate is about as broad as it can get, allowing U.S. stocks and bonds as well as foreign ones. This diversification, combined with the portfolio managers' conservative, dividend-focused approach, makes it the most conservative option on this list. Like the other two American Funds here, its research staff and portfolio managers are topnotch, and performance here is quite impressive.

Bottom Line: This is a great long-term option, particularly for investors who are looking to simplify their portfolios.

Fidelity Diversified International FDIVX
The fact that this foreign large-growth fund is even on a list of best-selling funds for the year is surprising--considering that Fidelity closed it to new investors in October 2004. Back then, it held $18 billion in assets; today that number is closer to $44 billion. Performance has been strong in absolute terms but not enough to explain that kind of growth. The reason it's possible is because existing shareholders can continue to add to their accounts. We are concerned with the fund's size, because it doesn't allow manager Bill Bower to be as nimble as he was in the past, and unlike the big funds above, this one has just one manager. We still think highly of Bower and expect the fund to do reasonably well, especially on a risk-adjusted basis. But existing investors might consider adding another international fund to their portfolios, and 401(k) investors should encourage their employers to give them an additional choice.

Bottom Line: Existing investors should stick with the fund but consider another foreign fund for additional purchases.

iShares MSCI EAFE Index EFA
This foreign large-blend choice has certainly raked in the dough in its five years of existence. With $33 billion in assets, it's now among the largest of its category. ETFs have generally become quite popular, and the MSCI EAFE Index, like the S&P 500 Index stateside, is easily the most recognized broad-market index. Its broad diversification thus makes it a good core international offering. However, there are limitations inherent in any MSCI EAFE-tracking vehicle, be it an ETF or conventional mutual fund. The most obvious is the index's lack of emerging markets and international small caps, which, granted, could prove a blessing in the near term considering how well those areas have performed over the past several years. As an index fund, this one is also refreshingly cheap.

Bottom Line: A good long-term choice, but investors will need additional funds to include emerging markets and international small caps.

Vanguard European Stock Index VEURX
Although this Europe-stock fund's returns aren't particularly special compared with its like-minded peers, in part due to its lack of soaring smaller-cap and emerging-Europe stocks, its absolute returns are enticing. Over the past year through Nov. 13, it has notched a 33% gain, helped not only by good stock market performance but also by a strong euro. But while we do expect this index fund to outperform is peers as European small caps and emerging markets cool, we don't think big double-digit returns are in the cards for the near term, particularly if the euro weakens versus the U.S. dollar. We certainly wouldn't suggest substituting a Europe-stock fund for a more diversified international holding. Using a Europe-stock fund as a supplement is okay, but investors should note the overlap between this fund and other, broader offerings.

Bottom Line: Fine as a supplemental holding.

Fidelity Advisor Diversified International FDVAX
Don't confuse this fund with Fidelity Diversified International. Although this foreign large-growth fund used to be run identically as its sibling, it changed course and managers in October 2004 (when Fidelity Diversified International was closed ... to new investors). Overall, the strategy hasn't changed much under experienced manager Penelope Dobkin, so the fund remains an appropriate core international holding for the long term, and its smaller asset base, at $14 billion, helps it retain some flexibility.

Bottom Line: A high-quality foreign offering with a lot working in its favor.

Vanguard Total International Stock Index VGTSX
Unlike the two other index offerings on this list, Vanguard Total International Stock Index includes emerging markets. Over the long haul, we prefer that to the developed-market index funds. It makes it easier (and cheaper) for investors to gain broad foreign-stock exposure in just one place. Of course, that "pro" can quickly become a "con" when emerging markets are swooning, as they were earlier in 2006. And given how well they've generally performed over the past several years, we'd expect the emerging-markets slice to hurt the fund in the near to intermediate term.

Bottom Line: A topnotch index pick for investors looking for broad foreign-stock exposure.

Bridget Hughes is an analyst with Morningstar.

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