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A Tough Time for All International-Stock Funds in 2018

Plunging foreign markets and unfavorable currency trends weigh heavily on results.

It was a tough 2018 for equity fund investors with money in the U.S. market: The S&P 500 lost 6%, and the Nasdaq fell 4%. But results were worse for those invested in markets outside the United States. The MSCI EAFE Index of developed markets plunged about 14% in U.S.-dollar terms, as did the MSCI ACWI ex USA Index (which includes a hefty dose of emerging markets). A variety of concerns hurt international markets, from local political issues to dismal economic data to the global impact of U.S. policies. Many stock markets abroad posted deeper losses than those in the U.S.

However, that wasn't the only problem for U.S.-based investors in international funds. In 2018, currency exposure also played a role. With the exception of the yen and Swiss franc, most foreign currencies lost a good amount of value against the U.S. dollar for the year. As a result, U.S.-based international funds suffered from currency losses on top of stock market declines. To illustrate, the currency effect took about 3 percentage points off the MSCI EAFE Index's return; that commonly used benchmark dropped 11% in local-currency terms but 14% when converted to U.S.-dollar terms. (Only a few equity funds avoided this effect by hedging all of their currency exposure into the U.S. dollar, though many partially hedge.)

As a result of the stumbles in foreign markets and the unfavorable currency translation, all of the non-U.S. style box Morningstar Categories--foreign large value, foreign small/mid-growth, and the like--posted steeper average losses for 2018 than did their counterparts on the U.S. side. For example, the large-growth category (for U.S.-focused funds) lost 2%, while the foreign large-growth group plunged 14%. The small- and mid-value categories on the U.S. side suffered badly--down 15% and 13%, respectively. But their plight was less severe than the combined foreign small/mid-value category, which sank 19%.

Meanwhile, the diversified emerging-markets category--which captures investments in countries outside of the MSCI EAFE Index--had a tough year as well, down 16%.

Many problems sank foreign-stock funds. Economic growth in the U.S. was much stronger than that of Europe, where the trends that finally had moved in a positive direction reversed course, with growth rates down to just above zero or even slipping into negative territory in some countries. Europe's biggest market, the United Kingdom, has been convulsed by uncertainty over the details of its path to exit the European Union, denting investor confidence in the British stock market and the pound. Political shocks in Italy and other European countries didn't help matters.

And though Brazil's beleaguered market actually held up well, emerging-markets funds were hurt by a sharp decline in the Chinese Internet stocks that had powered rallies in 2017. (China is a huge part of the standard benchmark, the MSCI Emerging Markets Index.) Alibaba BABA, Tencent, and Naspers (based in South Africa but with a substantial stake in Tencent) are all in the top five of that index with a combined weighting of 10%, and each dropped between 15% and 30% for the year. Baidu BIDU, just outside the top 10, also plummeted. Little wonder that the China-region category fell nearly 20%, the worst showing of any Morningstar Category--stock or bond, U.S. or international, broad-based, regional, or sector-specific--except for equity energy, which suffered a 27% loss.

One little-remarked-upon difference between U.S. and foreign funds this year was that performance among various investment styles was much more condensed on the foreign side. The difference between the loss of the best-performing foreign style-box category and the worst was just 5 percentage points. In the U.S., it was more than 13 points. The markedly better showing of the growth categories in the U.S. helps explain that discrepancy.

There were some surprises among individual funds. One of the all-time best foreign-focused funds, Oakmark International OAKIX, was one of the worst performers in 2018. Led by David Herro, this fund has outperformed for decades. But the contrarian, patient tendencies that have enabled it to assemble that outstanding long-term record also render the fund vulnerable to unfavorable market sentiment at times. The fund lost 23.4% in 2018, nearly 10 percentage points behind the MSCI EAFE Index and scraping the bottom of the foreign large-blend category. It's not hard to see why. Several big European banks populate the upper reaches of Oakmark International's portfolio, with allocations of 3% to more than 4% each. For many years, Herro has had more faith in these banks than his peers have. All were crushed last year. Other top holdings, such as Daimler DAI and Hennes & Mauritz, also suffered badly.

At the less-damaging end of the foreign large-blend spectrum was FMI International FMIJX. That fund did suffer a loss of 9.5%, which is far from negligible. But it fared far better than the indexes and nearly all other foreign large-blend funds. It had several things going for it, besides nice individual picks such as Whitbread WTB, a top holding that ended the year up about 17%. First, it had a cash stake that provided a cushion in a falling market. Second, it owned very few banks. And third, it is one of the only funds that, as a matter of policy, hedges most of its foreign-currency exposure into the U.S. dollar.

How about a fund that's designed to hold up better than most in market downturns? First Eagle Overseas SGOVX, which uses a cautious value-oriented approach, almost always holds some gold and a substantial cash stake as well. It did outperform in 2018, though it certainly didn't avoid losses. The fund declined 10.2%, about 4 percentage points better than the decline suffered by the foreign large-blend category average and the indexes. While the fund's cash and some helpful picks worked in its favor, deep losses in some longtime holdings--most notably British American Tobacco BATS and Fanuc of Japan--kept the fund from providing more of a cushion for shareholders than it could have.

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