Foreign Funds May Not Offer
Much Portfolio Diversification

Some bad news for investors with international-stock mutual funds: The funds may not provide as much diversification as you think.

As the U.S. stock market gyrates, mutual-fund firms and financial advisers have once again started pitching international funds as an ideal way to reduce risk in a U.S.-oriented portfolio. After all, overseas markets don't necessarily follow the movements of the U.S. market. And in times when the U.S. market may weaken, overseas markets can compensate with gains.

The message hasn't caught on strongly, however. Last year, Asian markets plunged, followed by jitters this year over Russia's market. Many alarmed investors fled from international funds. Over the past few months, the sector has experienced sporadic selling by investors, according to AMG Data Services, Arcata, Calif., which tracks mutual-fund buying and selling, or flows.

And now comes an analysis from Standard & Poor's Micropal, a Boston fund tracker, that questions the diversification benefits of international funds. The firm recently examined the correlation between the monthly returns of an international index, the FT S&P World Index excluding the U.S., against the returns of the S&P 500 to see how closely they matched each other.

Micropal's finding: The correlation between the returns of the international index and the S&P 500 has increased sharply, particularly since mid 1995. Using a statistical measure where one equals perfect correlation, Micropal discovered that the correlation between the international index and the S&P 500 is currently at 0.64, nearly tripled from a July 1995 correlation measure of 0.23.

"While there is still a sufficient lack of correlation between the U.S. and international markets, investors are gaining less of a diversification benefit than previously," says David Masters, senior fund analyst at Micropal. "Markets are moving more in unison, so it's getting difficult to spread risk."

At first glance, this analysis appears to fly in the face of logic. After all, how can the correlation between an international index and the S&P 500 grow at a time when so many foreign markets -- especially in Asia and Russia -- have gone in the opposite direction to the rise in the U.S. market?

Mr. Masters explains that the international index is weighted on a market-capitalization basis. So some markets' share in the index, such as Asia's markets, has decreased as the markets themselves have declined. Currently, the international index is composed mainly of markets with larger market-capitalizations -- that is, primarily European markets. And European markets have traditionally tracked Wall Street more closely than other foreign markets.

Henrik Strabo, senior vice president at American Century Investment Management, says he isn't surprised by Micropal's finding. European markets have undergone a renaissance in the past two years as companies there have started restructuring. European markets have soared, and thus boosted their market-capitalizations and their weights in international indexes. And as the markets have risen, they have increasingly correlated with the soaring U.S. market, he says.

Yet Mr. Strabo and other fund managers argue that Micropal's study doesn't invalidate international funds as diversification vehicles. There is a difference between an international index and an international fund because many international funds don't follow the weightings of an international index, they argue.

Consider Kemper Global Blue-Chip Fund, which also has investments in the U.S. The fund's manager, Diego Espinosa, notes that the portfolio's weightings are currently very different from those weightings in the Morgan Stanley Capital International World Index, which Mr. Espinosa uses as a reference point. While the index has about 50% in the U.S., the Kemper fund has only 33% of its assets there. And though the index has 10% in Japan, Mr. Espinosa's fund has only 4% of assets there.

"Indexes are a performance-measurement tool, not a performance-management tool," observes Mr. Espinosa.

Bob Bingham, a San Francisco financial planner, suggests that investors maintain 15% to 25% of their assets in international funds. Over the long term, correlations between international markets and the U.S. may rise, but will also fall, he says. When, for instance, Japan's economy recovers and its stock market rises, Japan's market-cap weighting in an international index will grow and the likely correlation of the index to the S&P 500 will decline.