Nowhere to Hide: Foreign Funds Are Falling, Too

I don't know about you, but I'm getting used to this: My U.S. stock funds are stinking. I don't like it, but I know in time, things will get better.

But what's up with foreign funds? From 2003 through most of 2007, foreign offerings easily outpaced U.S. ones, thanks in part to a weakening U.S. dollar (which helped as investment returns gained overseas were translated back into cheaper dollars) and surging emerging markets. The tide seems to have turned, though. Across the board, foreign funds have fallen a bit harder so far in 2008 than U.S. ones. And in fact, every single diversified foreign-stock offering (from the five categories listed below) is in the red. What gives?

Times Have Gotten Tougher for Foreign Funds, Too
Category	YTD Return	One-Year Return
Large Value	-14.48	-20.28
Foreign Large Value	-13.35	-16.71
Large Blend	-12.84	-15.66
Foreign Large Blend	-13.31	-14.17
Large Growth	-12.43	-11.03
Foreign Large Growth	-13.53	-12.31
Small Value	-8.36	-19.71
Foreign Small/Mid Value	-13.49	-22.53
Small Growth	-12.69	-16.43
Foreign Small/Mid Growth	-14.89	-20.09
* Returns through 07-21-08.

Globalization Gone Bad
Part of what's gone wrong with foreign offerings can be traced back to the U.S., in a way. The subprime crisis that set off a big correction in financials stocks last summer hasn't been limited to U.S. companies. MSCI EAFE Index heavyweights and popular foreign-stock holdings  UBS (UBS),  Royal Bank of Scotland (RBS), and  Barclays (BCS), for example, have all dropped more than 30% for the year to date through July 21, as those banks have taken substantive write-downs (or worse--Royal Bank of Scotland also had to raise more capital and paid too much for an acquisition). Overall, foreign funds tend to have more in financial services than their U.S. counterparts. That has stung, considering the financials sector has been the worst-performing group over the past year by a long shot.

Tight Correlations
Investors have long thought of their foreign offerings as providing some diversification benefit for their U.S.-centric portfolios. Although global markets are hardly negatively correlated--that is, they don't usually move in opposite directions for extended periods of time--they can have different performance drivers at different times, which can help smooth returns for investors over the long haul. In times of heightened volatility or during severe downturns, though, markets tend to become more tightly correlated, as pessimism spreads around the world. We saw global market correlations spike, for instance, during the bear market that began in March 2000, as well as in 1987 and at other times of stress. This time seems no different: Over the past year, foreign-stock and U.S.-stock categories have behaved more similarly than they did in the three years prior to that. When markets churn, it seems, everybody hurts. We've long argued, though, that investing overseas is more about an expanded opportunity set and less about diversification; that's especially true as companies around the world become more globally minded.

China, India, et. al.
Most diversified foreign-stock funds don't have a whole lot of exposure to emerging Asia. But the drubbing that many emerging Asian stocks have taken means that even small positions can still have a meaningful impact. Consider that China and India stocks have plummeted more than 40% so far in 2008. Other emerging-Asian markets haven't fallen by as much, but Hong Kong, Malaysia, and South Korea are all off more than 20%. Remember that these markets had been on a tear for much of the past five years, though, so they were bound to give up some of those unsustainably high returns. And valuations on some Chinese and Indian stocks had reached exuberant levels. Plus, there are legitimate concerns when it comes to China, including its reliance on oil and inflationary pressures; we provide more detail here.

Japan
To be fair, Japan has been one of the better-performing markets so far in 2008. Still, it has dropped around 10%. That's hardly comforting, especially considering it also lost money in 2007, while most markets posted big gains, and was a laggard in 2006. Many investors considered Japan a defensive market where cheap valuations could be found. That may be true, but investors should remember than even cheap stocks can get cheaper (that is, fall). But a handful of widely held stocks, including  Toyota Motor Corporation (TM),  Sony (SNE), and Takeda Pharmaceutical have dropped considerably. Japanese banks have held up better than U.S. and European counterparts, but several are still down so far this year.

Not All Is Wrong with the World
There have been some bright spots for foreign-fund owners. As is true with U.S.-stock funds, investments in some energy, commodities, and materials stocks have continued to do well. That's meant that resource-rich countries like Russia, Brazil, and those in the Middle East have held up well. And for the most part, the dollar has continued to weaken. Specifically, the euro, Japanese yen, Australian dollar, and Swiss franc have all gained appreciable ground in the first six and a half months of 2008. (The dollar has been roughly flat against the British pound.) A weak dollar is not necessarily something for U.S. citizens to celebrate, but there is that silver lining for international investors, when investment gains made overseas are translated into U.S. dollars.

Keep Your Long-Term Perspective
I've painted a pretty bleak picture, I know. But before you fall into deep despair, I'd remind you that the late Sir John Templeton made a highly successful career investing where he saw "maximum pessimism." We've been here before. Markets are cyclical. Keeping a truly long-term perspective (10 years or more) can be liberating, and you may realize this is a time to add to your holdings.

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