By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- We've taken the search for the Holy Grail of mutual funds global.
In August, MarketWatch hunted for diversified U.S. stock funds with low risk and expenses, above-average returns, high tax-efficiency and tenured managers. Just two dozen passed our test. See full story.
To find international-stock funds with similar qualities, MarketWatch again enlisted investment-research firm Morningstar Inc. The screen we constructed excluded country-specific funds and other narrowly cast portfolios as well as so-called world funds that can hold U.S. stocks.
As with the U.S. search, the qualifying field was thin. Of 286 international funds with a five-year track record, only nine offerings open to retail investors made the cut.
Conventional wisdom recommends putting at least 10% and even 20% of a stock portfolio outside of the U.S. The goal, as always, is diversification. While developed European markets tend to perform more like the U.S. than emerging markets, international investments in general aren't mirror images of their U.S. counterparts. Having money abroad stabilizes a portfolio.
"Even if the returns are the same, they should take place in different time frames," said Kevin Ellman of Wealth Preservation Solutions, a financial adviser in Ridgewood, N.J. "That would serve to smooth out the peaks and valleys in the portfolio. That's why we do it."
The nine funds that passed muster in our screen mostly invested in growth stocks or were a blend of growth and value styles.
The screen's highest-rated fund in Morningstar's foreign small/mid growth category was the MFS International New Discovery Fund /zigman2/quotes/209431037/realtime MIDAX -0.37% . Manager David Antonelli and his colleagues spread risk among almost 300 stocks in the $3 billion portfolio with most of its focus on financial services and manufacturing sectors.
The MFS portfolio carries a 5.75% front-end sales charge, or load. A top no-load offering in the same category is Neuberger Berman International . The $687 million portfolio has large positions in Europe and Japan, namely in energy and financials.
In the foreign large/blend category, Thornburg International Value /zigman2/quotes/201544140/realtime TGVAX -0.94% was a standout. The $3.5 billion fund carries a 4.5% front-end load, and its focused portfolio has significant stakes in consumer goods and financial-services companies across Europe and Asia outside of Japan.
An appealing no-load alternative: UMB Scout WorldWide , a $1.6 billion fund with a concentrated mix of health-care, energy and consumer stocks.
The case for foreign exposure
International stocks -- especially in emerging markets -- have solidly outperformed their U.S. rivals for several straight years.
"The numbers are telling the story," said Gregory Sullivan of financial adviser Sullivan Bruyette Speros & Blayney in McLean, Va. "It was harder three years ago to talk about international than it is today. People now are more comfortable with that conversation and more open to increasing their allocation."
Funds in Morningstar's foreign large-blend category, which own large-capitalization stocks, returned almost 18% annualized over three years through Thursday. In contrast, domestic large-blend funds averaged 12% gains over the same period.
Those gains, expressed in U.S. dollar terms, have been enhanced by the weak greenback. Not surprisingly, American investors, lured by higher returns, have been softening their home-country bias and putting more money abroad.
"The reasoning for international goes beyond returns," said investment adviser Ross Levin of Accredited Investors in Edina, Minn., who targets 30% of his clients' total portfolio to non-U.S. investments. "It goes to basic portfolio strategy, and it makes tremendous sense."
The lack of qualifying funds on the Morningstar screen doesn't indicate a lack of quality international fund offerings.
Some highly regarded investments, such as the Dodge & Cox International Stock Fund /zigman2/quotes/207409772/realtime DODFX -1.13% and Artisan International /zigman2/quotes/203048912/realtime ARTIX -0.88% didn't make the grade because their five-year risk figures were above average.
Morningstar measures a fund's return over the U.S. Treasury note, compared to similar portfolios. To determine risk, Morningstar tracks fluctuations in a fund's monthly returns against comparable funds. The least-volatile portfolios are considered low risk.
Some respected funds like Artisan International Value /zigman2/quotes/207322356/realtime ARTKX -0.55% weren't included because their managers have been on the job less than the screen's four-year minimum. Others, such as First Eagle Overseas /zigman2/quotes/209014684/realtime SGOVX -0.71% and Julius Baer International Equity /zigman2/quotes/200813524/realtime JIEIX -0.60% are closed to new investors -- though the Julius Bear managers recently launched a sibling, Julius Baer International Equity II /zigman2/quotes/208682313/realtime JETAX -0.97% .
And mutual funds aren't the only option for international diversification. Many investment advisers are stepping up their use of exchange-traded index funds to fill that role.
"You could build an interesting international portfolio using exclusively ETFs if you don't want to research actively managed funds," Levin said.
Focused ETFs that Levin uses include iShares MSCI Emerging Markets Index /zigman2/quotes/201454250/composite EEM -0.41% , iShares MSCI Japan Index /zigman2/quotes/201162210/composite EWJ +0.09% and iShares S&P Global Healthcare Sector /zigman2/quotes/200402559/composite IXJ +0.44% .
Still, while indexing has appeal, Levin and other financial advisers agree that actively managed international funds -- particularly those that scour volatile emerging markets -- have an edge.
"International is one place where active management seems to add value," said Jim Peterson, vice president of the Schwab Center for Investment Research.
"There's more opportunity, because some of these countries are less-followed, to find stocks that are going to beat the market," Peterson added. "To the extent that a manager works on country selection and dips down into small-cap and emerging markets, you have an opportunity to outperform."
Even fund expenses -- so crucial to investment results -- aren't as important internationally as they are with domestic strategies, Peterson said.
"Expenses aren't as predictive of which funds are going to do well in the international space," he noted. "That suggests that international managers are able to make up for higher expenses through performance."
Here's a look at five low-risk international stock funds that have performed well over the last five years and four additional funds that also survived our screening:
Four additional qualifying funds
Source: Morningstar Inc. (Data through 9/8/05)