With U.S. and foreign markets moving more in sync, are international funds giving me the diversification I need?

QUESTION: Given that correlations between international equity markets have gone up recently, does it make sense to continue to diversify with international funds?

-- Eric Dobkin   
ANSWER:

That's not to say the naysayers don't have a point. Over the past few years, U.S. and foreign markets have indeed moved closer together. The correlation between the two increased to 0.72 at the end of 2000, compared with 0.44 at the close of 1995, according to Ibbotson Associates. (A correlation of 1.0 indicates perfect sync, while zero indicates complete independence.) This rising correlation isn't entirely surprising, since markets historically tend to move more in sync in times of economic distress.

But overall, U.S. and foreign stock markets are forecasted to display greater independence over the long term, says Don Cassidy, senior research analyst at Lipper. Differences should emerge as economies such as China's, for example, continue to develop. So if you have a long-term investment horizon of, say, 20 years, the recent correlation may not mean much. And shying away from foreign funds means shutting yourself out of an increasing proportion of the market: In the 1970s, U.S. markets accounted for almost 75% of the world's total market capitalization; today, that level is down to 50%.

The fact is many investors have lost interest in foreign funds not so much because of the lack-of-diversification argument, but because of the lack of stellar returns. Consider that diversified domestic portfolios have delivered an annualized 12% over the past five years, while diversified international stock funds gained a relatively meager 5%, according to Morningstar data. But obviously there are funds that buck this trend. Just look at our recent fund screen.

If you opt to add a little international flavor to your holdings, you should be sure it fits well with the rest of your portfolio, says Morningstar fund analyst Kunal Kapoor. For example, if you own diversified U.S. funds, then don't seek the same type of portfolios overseas. "If you're going to buy mainstream, large-cap-growth foreign-stock funds," he says, "you're not really adding much to your profile." That's especially true since both U.S. and international large-cap funds often contain similar top holdings, such as Finland's Nokia (NOK) and United Kingdom firms GlaxoSmithKline (GSK) and Vodafone (VOD).

Instead, Kapoor suggests choosing a foreign fund that fills some other gap in your portfolio. If you're heavy on growth funds right now, for example, you could consider value-oriented foreign-stock funds, such as the Oakmark International fund (OAKIX) or Longleaf Partners International fund (LLINX). Overweighted in large caps? Small-cap international funds are another diversification option, says Cassidy. Such holdings can add some balance to a portfolio chock full of multinational behemoths.

If you really want some diversification, there are always emerging-market funds, which certainly don't follow U.S. markets. Of course, this highly volatile bunch isn't for the faint of heart. With the average emerging-market-fund return in negative numbers over the past one-, three- and five-year periods -- and a standard deviation (a measure of volatility) of 33, compared with the S&P 500 at 20 -- there's been plenty of risk without much reward lately. Compounding the risk: "People have heard that in still-developing parts of the world, financial-reporting standards are not up to snuff," says Cassidy, who also notes fears of political unrest and bribery. A skilled emerging-markets fund manager can dodge most perils, but if you do choose to diversify your portfolio with one of these funds, you may want to make sure that it's only a tiny part of your total holdings.

No matter what, when looking to add some diversification by investing overseas, be careful when considering a "global" fund. These funds, as opposed to international or foreign funds, usually need to invest in a total of only three countries, including the U.S. And with the majority of their assets in U.S. stocks, global funds clearly aren't going to give you the overseas exposure you're looking for.