The Year in International Funds

Most investors in international-stock funds are sitting on hefty gains this year. However, to maintain their comfort level, they should avoid peeking at comparable United States-focused funds. One of 2013's most noteworthy stories is that, by and large, the U.S. market had the edge. Through Dec. 19, all nine of the domestic-stock Morningstar Style Box categories (large value, small growth, etc.) boasted higher average returns for the year to date than the top foreign-stock style-box group, foreign small/mid growth.

Granted, the Morningstar Categories are not entirely equivalent: On the foreign side, we group small-cap and mid-cap funds together, while U.S.-focused small-cap funds get their own categories. With small stocks posting the strongest gains around the world this year, it's no surprise that pure small-cap categories would beat collections that combine small- and mid-cap funds. However, that alone doesn't nullify the comparisons. After all, even the mid-cap and large-cap categories on the U.S. side beat the foreign small/mid groupings.

Interested readers can take a look at the updated figures for all categories on this page. In particular, check out the huge gap between the best-performing international group (foreign small/mid growth, at 22.6% as of Dec. 19) and the lowest performer of the U.S. categories (large value, at 28.3%) In fact, not even the specialized foreign categories could compete. The return of the top-performing international-stock category, Japan stock, doesn't even approach that of the last-place U.S. category.

What Gives?
Various studies have shown that a country's stock-market performance does not necessarily mirror its rate of GDP growth. But that doesn't mean the two can't be related at times. It seems likely that a key driver behind the difference between U.S. and foreign fund performance in 2013 was the fact that investors generally had more confidence in the U.S. growth outlook than the outlook for Europe (where the bulk of foreign-stock fund assets reside), even though the prospects for the latter brightened this year.

A second reason: falling foreign currencies. Most U.S.-based mutual funds do not hedge their foreign-currency exposure back into the dollar. And with rare exceptions, those funds that do hedge tend to target only a portion of their currency exposure, and for limited time periods. The returns of unhedged (or mostly unhedged) funds get an extra boost when currencies rise in those foreign countries in which they own stocks. But the opposite happens when currencies fall.

And while some currencies--the euro, Swiss franc, and U.K. pound--held their own or even gained a bit against the greenback in 2013, many others, including the yen, the Canadian and Australian dollars, and a number of emerging-markets currencies, suffered steep declines. That put a dent in the returns of funds that had substantial holdings in such countries.

Finally, while the talk of the Federal Reserve pulling back on its bond-buying program caused concerns in U.S. markets, it took an even greater toll overseas, particularly in emerging markets. Those worries, combined with a variety of local concerns, held many emerging stock markets to modest gains this year, or even pushed them to losses. The falling currencies added to the distress. As a result, the diversified emerging-markets category s down 1.7% through Dec. 19. The effects were felt in the broader categories as well.

Bright Light in the East
One area that helped funds that were overweight there, however, was Japan. A strong rally began in this chronic laggard in late 2012, sparked by optimism about reforms implemented and promised by the new prime minister. The extraordinary rally continued well into 2013, stalled in late spring, and then ramped up again recently.

One impetus was the decline of the yen, a development that investors felt would boost the prospects for Japan's many exporters (whose goods would cost less abroad). The currency decline meant that unhedged funds didn't receive the full gains of the stock rally. But the stocks rose so much that even with the currency drag, it helped to have a hefty dose of Japan this year, unless a fund managed to pick the relatively few stocks that didn't join the party.

It says something about the years of sluggishness in the Japanese stock market that the country's longer-term returns are still unimpressive. Even with this year's success--as noted, the Japan-stock category sits atop the 16 international-stock groups--that category still ranks a lowly 15th out of the 16 for the trailing five-year period. Only India equity, which has had a terrible 2013, has been worse over the five-year stretch.

Explaining Fund Performance
For actively managed funds, it's dicey to assume that country weightings or currency exposure alone can fully explain their performance. Individual stocks don't always follow the trend of the overall market--as those managers who owned shares of Japan's  Komatsu (KMTUY), which suffered a substantial loss this year, can attest. Still, when there are large divergences in the performance of different countries or regions, currencies, market caps, or sectors, weightings in various areas often do provide some guidance for investors trying to understand their funds' performance.

This year, funds with large emerging-markets stakes, and underweight in Japan, were likely to lag. Positions in India, Brazil, the Philippines, or Indonesia could be particularly detrimental. And with modest optimism about economic growth replacing longstanding pessimism, some former safe-haven areas, such as tobacco stocks, lost their luster. That hurt funds such as  Wintergreen that hold relatively large positions in such stocks. 

Meanwhile, owning mining stocks this year was even more painful; with huge losses common among such companies, even small amounts in a fund portfolio could hit returns. (Morningstar's equity precious-metals category, which houses specialized mining-stock funds, has dropped a staggering 50.8% this year.)

By contrast, a fund that had not just one but two of the year's hot trends in its favor was in prime position to succeed. Fidelity Japan Smaller Companies (FJSCX) actually is more all-cap than small-cap, but it nonetheless has gained 46.5% this year, almost double the hefty Japan category average.

All in all, therefore, the climate for international funds was more varied, and more treacherous, than it might seem from a quick look at the big gains posted by major indexes and prominent funds. For that reason, assessing the determinants of performance requires some digging, and while the broad trends outlined above can provide guidance, examining the specific holdings in an individual fund's portfolio and how those might have changed over the course of the year remains the most reliable method of evaluation.