For years I've held a European-stock fund as a way to diversify my portfolio. But does it really offer the diversification I seek?

QUESTION: It used to be said that holding a small part of your mutual-fund portfolio in foreign funds made good sense as a way to balance out holdings. For years I have had the Vanguard European Stock Index fund (VEURX) with that in mind, but with the U.S. and European markets both stuck in the doldrums, does it still make good sense?

-- P.S.
ANSWER:

Two years later, domestic investors continue to doubt international-equity investments. This time, however, it's because international funds are sagging even lower than their stateside counterparts. Year-to-date, diversified U.S. stock funds are down almost 16% on average, while diversified international-equity portfolios have lost more than 22%. To top things off, U.S. and foreign markets have become increasingly correlated since the global economic crisis of 1997 and 1998, and the Sept. 11 terrorist attacks have only reinforced this synchronized movement.

Both forms of skepticism, however, involve short-term thinking. "When you diversify, overseas investments are not going to protect you from near-term shocks," says Russel Kinnel, director of fund analysis at fund-tracking firm Morningstar. "What's going to do that is bonds and cash in your portfolio." In order to see the benefits of diversification, you'll need to look out further than a few years. When you examine the past few decades, for example, you'll notice that U.S. markets did not always reign. In the 1970s, European stocks ruled. In the 1980s, Japan was the kingpin. "In two out of three decades, the U.S. was not the place to be," says Kinnel. "I'm not sure you'd want to give that up, even if markets are a little more correlated." And while hulking multinationals have helped to create a more global landscape, smaller companies and those located in emerging markets are much more likely to still march to their own beat. So perhaps the question here isn't should you own an international fund, but more so, are you holding the right one for your portfolio?

Certainly, the basic idea of an international fund makes sense. After all, overseas markets now account for approximately 50% of the world's total market capitalization, compared with only 25% in the 1970s. "It doesn't make sense to ignore good companies simply because they're in Europe and Japan," notes Kinnel. And while top foreign firms such as Nokia (NOK) are found in many U.S. funds, smaller players aren't. So you could seek out funds that focus on smaller-cap foreign investments, such as Pictet International Small Companies fund (PTSCX) and Longleaf Partners International fund (LLINX).

Europe, too, may have several advantages over the U.S., due to fundamental differences in the markets, notes Stuart Schweitzer, global investment strategist at JPMorgan Fleming Asset Management. For instance, the Continent didn't experience the same level of capital-spending excess as the U.S. in recent years, nor does it labor under a similarly huge current account deficit. "And while the U.S. dollar has been exceptionally strong despite that deficit," says Schweitzer, "we believe the dollar will gradually erode in value vs. the euro." That should give a leg up to international portfolios, especially those that don't engage in currency hedging.

Now, as far as your specific choice, the Vanguard European Stock Index fund, is concerned, don't get us wrong: This is a solid large-cap European-stock fund, with a super-low expense ratio of 0.29%. It's a good option, especially if you don't have time to re-examine your portfolio on a regular basis. However, you should note that this fund probably won't give you a hefty dose of diversification, as indicated by its R-squared vs. the S&P 500 index. (The R-squared is one way to determine a fund's correlation -- or lack of it -- with an index. Perfect correlation with an index is reflected by an R-squared of 100, while any figure above 80 implies that it will move in relative sync.)

While the Vanguard fund's R-squared relative to the S&P 500 is 58 -- not that high -- other fund choices are far less correlated. The small-cap Pictet International Small Companies fund, for example, sports an R-squared of only 22 against the S&P 500. Other funds that may offer more diversification include value-oriented foreign-stock funds, such as the Oakmark International fund (OAKIX) or Tweedy Brown Global Value fund (TBGVX). The R-squared figures of these funds against the S&P 500 are 42 and 38, respectively.

We are firm believers that it's a good idea to go abroad. Just be sure to pick the destination carefully.