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July 8, 2007, 12:01 a.m. EDT

Global Stock Funds: Any Room Left?

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By Jaclyne Badal

The strong performance of foreign stocks has prompted many investors to dive into international-stock mutual funds. But advisers and analysts caution that latecomers should probably inch into the pool, instead.

Industry watchers expect global stock markets to be more volatile over the next 12 months, which means investors who place big bets now may be in for a bumpy ride. International funds are still a good buy, advisers say, but the best strategy may be to build up exposure to foreign stocks using "dollar cost averaging," which calls for investing smaller sums at regular intervals.

Tempering enthusiasm for a hot category is rarely easy, and international stock funds have been hot, indeed. So far in 2007, in a repeat of last year, investors have spurned U.S.-stock funds for their world-equity counterparts, which invest primarily overseas. In May, investors dumped $11.54 billion into foreign-stock funds while pulling $9.99 billion out of U.S. funds, according to the industry's Investment Company Institute in Washington. Year to date, about 87% of the money invested in stock funds has gone into international products.

The Case for Buying

The appetite for foreign-stock funds is driven by a five-year history of outsized gains, wariness about the U.S. market and optimism about earnings prospects overseas. And while analysts caution investors to moderate expectations for the future, they insist that a smart portfolio needs significant exposure to international equities.

Rewards of Going Abroad

"Why only fish in your backyard?" says Bill Stone, a senior vice president at PNC Wealth Management, a unit of PNC Financial Services in Pittsburgh.

Mr. Stone says PNC generally keeps 20% of a typical client's stock portfolio in international equities but that the company has bumped that allocation to 25% in recent years, second only to stocks of large U.S. companies. Foreign stocks still look reasonably priced, he says, with the Dow Jones Euro Stoxx 50, an index of blue-chip European firms, trading at 12 times estimated 2008 earnings, compared with 14.5 times for the Standard & Poor's 500-stock index.

He feels foreign stocks -- and the funds that invest in them -- have further room to climb. "But I wouldn't expect doubling performance," he says.

Andrew Lo, director of the MIT Laboratory for Financial Engineering at the Sloan School of Management in Cambridge, Mass., points to two factors with the potential to slow world-wide stock gains: rising interest rates, and the chance that a weak dollar could rebound.

Some central banks have raised rates in recent months -- including the Bank of England last week -- and others have suggested they may do so. Those moves could help long-term economic growth by keeping inflation in check, but higher rates can hurt stock returns in the short term by increasing borrowing costs for consumers and businesses.

Likewise, when the dollar goes up relative to foreign currencies, U.S. investors see their foreign-stock returns trimmed. That's because investments denominated in other currencies lose value when translated back to dollars. A stock that's stuck at 20 euros is worth $30 when a euro costs $1.50. But it's worth only $24 if a euro sells for $1.20.

Fund managers increasingly believe the dollar is going to strengthen, according to a June survey of global fund managers by Merrill Lynch. The bulk of respondents said the dollar is undervalued, while the euro and the British pound look rich.

In contrast, the dollar has generally been falling since 2002, which has boosted the returns to U.S. investors holding foreign shares.

In fact, remove the currency effect from a popular benchmark for international stocks -- the Morgan Stanley Capital International EAFE (Europe, Australasia, Far East) Index -- and foreign-stock returns are a lot less impressive.

Currency Effect

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