July 29, 2003 — The improving global economy, fading concerns about the SARS epidemic and the end of the war in Iraq proved to be a recipe for booming stock prices not just in the United States but in overseas markets as well. And U.S. investors who ventured abroad got an extra bonus in the second quarter: as the dollar fell against the euro and other currencies, their returns from those offshore holdings surged in dollar terms.

To market strategists and those investment advisors who urge their clients to keep anywhere from 10% to 40% of their stock portfolio invested in markets outside the United States, those second-quarter gains drive home an important investing lesson.

“You need to maintain allocations to international stocks at all times,” says Steve Peterson, vice president of Sand Hill Advisors, a Palo Alto-based investment advisory firm, who urges his well-heeled client base to keep at least a third of their equity holdings in foreign stock funds. “That’s the only way to be positioned when these rallies happen.”

Indeed, many investors missed out on all or part of the second-quarter gains. As the correlation between U.S. and overseas markets grew — and returns fell — beginning in the late 1990s, investors bolted. In 2001 and 2002, according to data from the Investment Company Institute, international funds saw total outflows of nearly $23 billion, and investors have been slow to return.

“The argument of old was that international investing provides diversification, and that certainly isn’t as strong an argument today,” says Roger Fenningdorf of Rocaton Investment Advisors LLC, a Norwalk, Conn. consulting firm. “But overseas investing opens up a much broader set of opportunities to investors, including some of the best companies in the world.”

Still, helping clients pick the right funds to maintain an ongoing exposure to foreign markets is a complex process. The one rule, for most advisers, is to use funds, and not try to pick stocks.

“This is one area where investment advisers are limited in their expertise, and need to know their limitations,” Peterson says.

Step one: Picking a Core Fund

Selecting a broad-based fund to serve as the core of the investor’s international-investing strategy is the first task. In most cases, this fund will represent anywhere from 50% to 100% of the entire overseas allocation, so it’s the most vital decision.

But investment advisors need to consider more than just the sector of the new fund they are studying. Standard & Poor’s suggests looking past the new wrapper and examining the quality and experience of the team managing the fund, as well as its track record and investment discipline. Both objective and qualitative information on portfolio managers and the structure of the firm is important, not only because it helps investors understand the fund better, but can provide guidance on what to expect going down the road.

“We want to find a manager whose portfolio is broadly diversified,” says Harold Evensky, a financial advisor in Coral Gables, Florida. “We want someone who may make some country bets, but maintains some kind of exposure to most of the important overseas markets.”

For Evensky — and many others — indexing overseas isn’t as attractive an option as it is at home. They believe active managers are better able to take advantage of the larger number of inefficiencies they believe exist in less liquid overseas markets.

Picking a core fund means choosing either an international fund (a fund that invests only outside the United States), such as 3-Star ranked Julius Baer Inv:Intl Equity Fund/A (BJBIX), a Standard & Poor’s Select Fund, or a global fund (one that invests in the best ideas around the world, including the U.S.) At first glance, the global approach offers many advantages: it gives the investor exposure to the fund manager’s best stock selections in the most promising industries, regardless of where they happen to be domiciled.

“It’s a very efficient way to capture the maximum benefits from global markets,” says Derek Sassveld, strategy analyst at UBS Global Asset Management. “We are big believers, as a firm, in giving investors access to a global set of opportunities.”

That approach can be rewarding. The UBS Global Allocation Fund/Y (BPGLX) was upgraded by Standard & Poor’s to 4 Stars from 3 Stars and boasts an annualized total return of 7.5% for the 10 years ended June 30, compared to a return of 3.3% for the FTSE World Index (ex U.S.). It jumped 14.16% in the second quarter.

But in practice, advisors may find it harder to work global funds into an investor’s existing portfolio, as their holdings may overlap with those of U.S. stock funds. “They really work best if an investor is looking for a one-stop shop solution, where they get global and U.S. exposure,” says Peterson. “But if your clients already have commitments to U.S. funds, it’s better to look at international funds.”

The Second Tier: Regional and Country Investing

Regional funds have fallen from favor since their heyday in the late 1980s and early 1990s, and have struggled to build assets. Some fund families have discussed rolling their small regional funds into their broader international offerings, as Legg Mason Funds proposed doing last February with its Legg Mason Europe Fund. Investors, they believe, are likely to continue to favor broader funds, and advisors agree that’s a better strategy.

“There are great country stories out there, like China and India, where growth is very strong,” says Sassveld. Country funds, however, add to costs: “you have to own more of them and monitor them more closely” to manage the risk. Getting the timing right, he adds, is virtually impossible.

For instance, analysts suggest that a less risky way to play the recent enthusiasm for Japanese stocks might be to find an international fund manager with an extensive knowledge of Japanese stocks, and an ability to overweight the Japanese market.

A more reliable way to capture regional variations, veterans argue, is by maintaining a separate allocation to emerging markets funds, such as 3-Star ranked Oppenheimer Developing Markets/A (ODMAX), Bernstein Fund:Emerging Markets Value Port (SNEMX) or Delaware Group:Emerging Markets Fund/A (DEMAX). “The dynamics are completely different,” says Fenningdorf. Emerging markets, he adds, “demonstrate different risk and reward characteristics.” A classic emerging markets fund should, for instance, be able to profit from such varied trends as Chinese economic growth, Venezuela’s recent stock market revival and the jump in Asian technology stocks.

Flavor of the Month: Small-Cap Investing

An increasingly popular way of maximizing diversification in overseas investing is overweighting small-cap stocks, which have the biggest exposure to local economic trends. And there are a growing number of funds that investment advisors hail as great ways to play the international small-cap sector, including the 5-Star ranked Oakmark International Small Cap Fund/I (OAKEX) and, for investors who prefer a value-oriented approach and don’t mind exposure to gold stocks, First Eagle Overseas Fund/A (SGOVX).

“This area is a pretty attractive one right now,” says Peterson. “That’s important when you’re selecting funds to add to your core holdings, and looking for something that will contribute something a bit extra to your portfolio.