A Checklist for Foreign-Stock Fund Investors

Foreign-stock funds have been as popular as the Monday-morning quarterbacking of Super Bowl XLIX. According to Morningstar's fund-flows report, international-equity funds, as a group, took in twice as many new dollars as U.S. equity funds in 2014. These flows weren't the result of chasing performance: Seven of Morningstar's nine international-equity categories posted negative returns in 2014.

What's the attraction? "These funds had double-digit returns in 2012 and 2013, so they were still pretty good going into the year," says Morningstar director of manager research Russ Kinnel. "In addition, a lot of news coverage has been devoted to the economic problems in the U.S., so people tend to think the grass is greener on the other side." In fact, despite recent pessimism about China's growth, European debt, and political instability in the Ukraine and elsewhere, many readers on Morningstar.com say they're either holding tight to their foreign-stock holdings or adding to them on weakness.

However, investing in foreign-stock funds can be trickier than scoring from the one-yard line (unless, of course, you're the Seattle Seahawks). Here's a checklist for investors to follow as they evaluate their current foreign-stock funds or add foreign-stock exposure to their portfolios.

Understand Overall Foreign-Stock Exposure Senior analyst Gregg Wolper, who has been analyzing foreign-stock funds for 20-plus years, suggests that investors begin by evaluating the foreign exposures of their U.S. stock funds. "The exposure is often greater than people think--it could be 15% to 20%," he says.

Moreover, even straightforward S&P 500 Index funds provide some exposure to overseas markets via the large multinational companies they own. In fact, many U.S. large companies derive more than half of their revenues from foreign markets.

While Wolper believes investors need to have a handle on their overall foreign-stock exposure to set appropriate expectations, he doesn't think investors should cleave too closely to a particular number. "Your overall foreign-stock exposure can change if your U.S. fund managers buy or sell some foreign stocks," he notes. As a result, trying to doggedly manage to a specific number could turn into a full-time (and return-detrimental) job.

• What's the Right Foreign Allocation?

Consult Analyst Ratings Morningstar's Fund Analyst Ratings are handy shortcuts for monitoring existing holdings and finding new investments. Funds that earn Analyst Ratings of Gold, Silver, or Bronze (also known as Morningstar Medalists) are expected to outperform their categories and their benchmarks over a full market cycle.

When assigning ratings, Morningstar analysts focus on factors that give funds long-term competitive advantages, such as repeatable and consistent investment processes, low costs, and deep manager and analyst teams.

As of this writing, 61 foreign-stock funds earn medalist ratings: 49 of those funds emphasize large caps, while the remainder invests in small- and mid-cap names.

• Fact Sheet: Morningstar Analyst Ratings

Drill Into Market Exposure While Morningstar Analyst Ratings are useful starting points when evaluating any type of fund, other considerations are unique to foreign-stock funds. Among them: the blend of markets in which a foreign-stock fund invests. For perspective, foreign large-cap funds tend to focus on Europe--specifically, established markets in France, Germany, Switzerland, the Netherlands, Spain, Italy, and the United Kingdom. They often hold significant positions in Asia, too. Foreign large-value and foreign large-blend funds tend to keep about 10% of assets, on average, in emerging-markets stocks. Foreign large growth's emerging-markets stake is typically a bit higher, around 15%.

Meanwhile, foreign small/mid-growth funds carry the largest emerging-markets stakes of all foreign-stock categories: 20%, on average. Their small/mid-blend and small/mid-value counterparts hold just 5% to 10% of their assets in emerging markets.

These figures are only averages, though; actual fund breakdowns differ. Knowing how a fund's market exposure diverges from the averages allows for better performance expectations--and better investor outcomes.

For instance, emerging-markets stocks tend to be more volatile than developed-markets stocks. "The average open-end fund in the diversified emerging-markets category has a 15-year Morningstar Risk rating of 6.2, while the typical open-end foreign large-blend fund has a 15-year Morningstar Risk score of 4.9," notes senior analyst Bill Rocco. As a result, stock funds with higher emerging-markets stakes, such as

In addition, funds carrying overweighted positions in Asia perform very differently from those overweighting Europe: In 2014, the Europe-stock category underperformed the diversified Pacific/Asia category by more than 7 full percentage points. An overweighting in red-hot India, for instance, helped drive

• What's an Emerging Market, Anyway?
• Economic Growth Doesn't Equal Portfolio Growth
• How Much Emerging-Markets Exposure Do You Need? (And Do You Already Have It?)

Examine Strategy and Style As suggested above, a variety of investment strategies and styles populate the foreign-stock fund categories.

Low-cost index funds from Vanguard, DFA, and Fidelity rank among our medalists. As Morningstar director of personal finance Christine Benz has noted before, "International index funds are on the ascent." Index-based foreign-stock mutual funds have posted competitive returns against their actively managed counterparts, thanks in large part to rock-bottom expenses and modest trading costs. They also tend to be more tax-efficient than active funds, and there's no star-manager flight risk. Not surprisingly, passive international funds have enjoyed greater inflows than actively managed foreign-stock funds: In 2014, passive international funds' net flows were $90 billion versus just over $54 billion for active strategies. That said, there are good reasons to go active in foreign markets. Notes Benz, "Index funds do not have the ability to retreat from dicey markets when the going gets tough, which is a technique that investors might value in a foreign-stock fund even more than in a U.S.-focused fund." Moreover, Morningstar studies have shown that, among international large equity funds in particular, the top-performing managers have been able to generate excess return over time.

Regardless of whether an investor goes active or passive, there are dedicated large-cap funds, focused small-cap funds, and wide-ranging all-cap funds practicing different growth and value strategies. Understanding a fund's style-box placement and its strategy allows investors to find funds that match their risk profiles, fill portfolio gaps, and set performance expectations.

• 4 Questions to Ask When Investing in Foreign Stocks
• Active or Index for Overseas Exposure?

Delve Into Currency-Hedging Policies

Two factors contribute to a foreign-stock fund's returns. The first, of course, is any gains or losses that the securities in the fund's portfolio generate. The second contributor to return is the gains or losses in foreign currencies versus the dollar. "If the stock appreciates and the currency in which it is denominated appreciates relative to the dollar over your holding period, you win on both sides of the trade," explains Benz. "But if the stock declines and the foreign currency declines, too, it's a lose-lose."

Whether a foreign-stock fund manager remains fully exposed to foreign currencies or swaps those currencies for U.S. dollars (called "currency hedging") can affect short-term performance. Most foreign-stock funds practice some form of currency hedging. Hedging sure made a difference in 2014, notes Wolper. The dollar strengthened against most other currencies in 2014, hurting foreign-stock fund returns. Those rare funds hedging most of their foreign-currency exposure back into the dollar, such as

• How Currency Risk Affects You
• 2014: The Year in International Funds