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Mutual Fund Outlook: Going Global

Investors continue to send piles of investment dollars abroad, as international stock funds, following a record year in 2006, attracted the most new money compared with other categories during the first-quarter.

While individuals have been increasing their overseas investments for the past few years, fund pros don’t expect the strength in international investment flows to abate anytime soon.

Is this a bad case of performance chasing? After all, international indices have outpaced their domestic counterparts – by more than double – for the past five years. While many investors are undoubtedly being lured by outsized results, some experts also believe that globalization has changed the way investors view foreign investments. There's also been a proliferation of new products to choose from.

“There is a big debate within the industry of whether this is people following performance or if this is really a shift in people’s attitudes toward international equity,” said Owen Concannon, senior research analyst at Financial Research Corp. “We think it’s the latter.”

During the first-quarter, of the $79.2 billion net inflows into all stock funds, $44 billion, or 55%, went into international funds versus $35.2 billion for U.S. stock funds, according to Morningstar. The bulk of foreign investments went into foreign large-cap blend funds and foreign large-cap value funds.

Of the $157.9 billion that investors put into stock funds in 2006, a whopping 93% landed in funds that invest primarily overseas, up from 77% in 2005 and nearly 38% in 2004, according to the Investment Company Institute.

Those are eyebrow-raising figures. But despite the increase in money flowing overseas, U.S. stock investors still only have about 22% of their total holdings in international global stock funds (leaving 78% of their total holdings in U.S-centered funds), according to Strategic Insight, an investment research firm in New York.

In recent years, financial advisors have been recommending that investors increase their allocation to international investments to further diversify portfolios while decreasing volatility and risk: putting 10% of a portfolio in foreign stocks was once considered aggressive, now many experts recommend allocating between 20% and 30%.

“There is always some fluctuation with monthly flows but the commitment to global diversification is here to stay,” said Avi Nachmany, director of research at Strategic Insight.

And despite their run-up, international stocks don’t necessarily look pricey, some experts say. “Even though international stocks have performed well, their valuations are still lower than for U.S. stocks, says Brian Gendreau, an investment strategist for ING Investment Management.

For instance, the MSCI EAFE Index - which represents developed markets in Europe, Australasia, and the Far East – has a forward price-to-earnings ratio of 15, while it’s 16 for the Standard & Poor’s 500, he said. Meanwhile, foreign companies are expected to log stronger earnings growth next year: German companies are expected to grow 12%, with 8% growth in France, 12% in Japan and only 7% in the U.S.

“I expect the fund flows to continue,” Gendreau said. “A cynic would say that U.S. retail investors are at this point chasing returns, but it is hard to sort that apart from market that have simply developed considerable momentum.”

It's also much easier for a retail investor to go global today than it was 10 or 15 years ago, he added, while fund fees and trading costs are lower.

Still, some experts are concerned that investors aren’t aware that a good chunk of international funds’ stellar returns can be attributed to a weak dollar. Most international stock funds are denominated in foreign currencies like the euro and pound, which have fared well versus the greenback, thus boosting results. For instance, while iShares MSCI France Index outperformed the S&P 500 by nearly 24 percentage points since the beginning of 2006, more than half of that was due to appreciation in the euro, TrimTab computes.

“International fund returns have been significantly pumped by foreign exchange rate moves and it’s led to deceptively high returns on international funds,” said Conrad Gann, chief operating officer of TrimTabs Investment Research. “We think retail investors are naively pursuing those returns. The excess in international flows has been too strong for too long to say this is a readjustment to a global economy.”

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