Do I need an international fund if I already own a U.S. fund of big companies that operate in foreign markets?

QUESTION: I've been told that I don't need to invest in an international fund since I already hold the Vanguard Total Stock Market Index Fund (VTSMX). The rationale is that many of the companies the fund holds have significant overseas operations, which gives me the coverage in the international market and the diversification of an international fund. What do you think?

-- Anonymous

ANSWER: We don't buy it. It's true that in today's global economy many big U.S. firms have become household names in countries all over the world. (McDonald's (MCD) and Coca-Cola (KO) immediately come to mind.) By holding shares of these companies, investors get indirect exposure to the economies where they do business. But does that eliminate the role of a good international fund in an investor's portfolio? We certainly don't think so.

Before we start building our argument for international funds, we'll concede that, yes, the Vanguard Total Stock Market Index fund does hold stocks of U.S.-based companies with considerable international exposure. Its top five holdings (as of April 30) -- General Electric (GE), Exxon Mobil (XOM), Citigroup (C), Microsoft (MSFT), and Johnson & Johnson (JNJ) -- all have extensive international operations.

Also, earlier this year, the fund switched its tracking index from the Dow Jones Wilshire 5000 to the Morgan Stanley Capital International (MSCI) U.S. Broad Market index. Unlike the Wilshire 5000, which lists only U.S.-based companies, the MSCI includes some stocks of companies that are based abroad, but have substantial operations in the U.S., according to Sonya Morris, a fund analyst with investment research firm Morningstar. "That does have a little bit of implication on international exposure," she says. "But I don't think it's going to be of major significance."

In other words, to get true exposure to foreign markets, you need an international fund. According to Morris, one of the major advantages of investing in foreign markets is the fact that economies run in different cycles, with the growth of one economy hedging against a fall in another. "While Japan may be experiencing economic difficulties, the U.S. is doing well (or vice versa)," Morris says. "Having exposure to both economies, you are diversified."

This diversification helps reduce risk. For example, while the U.S. economy has experienced some rough patches over the past three-year period and domestic equity funds have returned an average 5.9% annualized, international equity funds have returned an average of 9.1%, according to Lipper, a fund tracking company (Data as of May 31). And during the past year -- marked most notably by a weak dollar -- international funds outpaced domestic funds 14.0% to 8.4%.

The fact is, many of the world's largest companies are located abroad and remain outside of U.S. indexes, notes Michael Porter, senior research analyst at Lipper. "There are more companies listed abroad than in the U.S., so by overlooking them you are denying yourself the opportunity to buy the best and most attractively valued stocks in certain industry groups."

Indeed, you may be surprised to discover that many companies that have become household names in America aren't included in domestic indexes like the S&P 500 or the Wilshire 5000. Take a look, for example, at some of the top holdings of the various international indexes: DaimlerChrysler (DCX), maker of Chrysler, Dodge and Jeep, is based in Germany; GlaxoSmithKline (GSK), known for Aquafresh toothpaste and Nicorette gum, and HSBC Holdings (HBC) are U.K. companies; Toyota (TM) and Sony (SNE) are Japanese; Samsung Electronics comes from South Korea; and Nestle (NSRGY) is based in Switzerland.

In effect, the only way to own a piece of companies like these in a mutual fund is to own an international or global fund. (International funds invest 90% or more of their portfolio overseas, while global funds invest 25% to 90% of their assets in foreign companies, with the remainder of the balance invested in the U.S., according to Lipper's categorization system.)

Just how big a role international funds should play in one's portfolio depends on factors like risk tolerance and investment horizon. According to Porter, most strategists recommend that foreign funds make up 10% to 15% of an investor's stock portfolio.

For those wading out into international waters for the first time, Porter recommends a broad-based fund, such as the Vanguard Total International Stock Fund (VGTSX). It consists of three region-specific funds, namely the Vanguard European Stock Index (62.7%), the Vanguard Pacific Stock Index (26.1%) and the Vanguard Emerging Markets Stock Index Fund (VEIEX) (11.2%). As you become more sophisticated, you may want to increase your exposure to one particular market and invest in a country-specific or region-specific fund, or buy additional shares in either of the funds above separately.