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Foreign Equity Allocation for Mutual Fund Portfolios

by

Jack Piazza
Sensible Investment Strategies

Investors currently have more choices for foreign (international) mutual funds than they had in the past. However, with these choices come more essential questions: what are the varying degrees of risk between the different type of funds, how does this risk relate to my personal risk tolerance, what type of foreign funds should I consider and what percentage should I allocate to my overall portfolio?

       Lets first examine the different types of foreign equity funds:

Diversified International - these type of funds invest primarily in economically well-developed, broad-based countries outside of the United States, using the MSCI EAFE Index as a benchmark. According to Morningstar, these developed markets currently include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, and the United Kingdom.

The main objective of these funds is long-term capital appreciation, whether using value, blend or growth strategies. A value-style strategy focuses on stocks that are believed to be undervalued in price and has potential to return to a "fair market" valuation. By contrast, a growth-style strategy emphasizes stocks which have the potential to sustain high rates of revenue or earnings growth; these growth-style strategies usually have higher risk compared to value-style strategies. Many Diversified International funds also have the option to invest a limited percentage of assets in emerging markets.

  • Foreign Large Value - majority of assets invest in large-capitalization foreign stocks that have low price/book and price/cash flow ratios.
  • Foreign Large Blend - majority of assets invest in large-capitalization foreign stocks, where neither value-oriented or growth-oriented characteristics predominate.
  • Foreign Large Growth - majority of assets invest in large-capitalization foreign stocks that have high price/book and price/cash flow ratios.
  • Foreign Small/Mid Value - majority of assets invest in small and mid-capitalization foreign stocks that have low price/book and price/cash flow ratios. Underdeveloped markets have a greater role compared to the foreign large capitalizations.
  • Foreign Small/Mid Growth - majority of assets invest in small and mid-capitalization foreign stocks that have high price/book and price/cash flow ratios. Underdeveloped markets have a greater role compared to the foreign large capitalizations.

Global (World) - this fund type invests primarily in diversified and established large-capitalization markets, including at least 20% in the United States. The main objective of these funds is long-term capital appreciation, usually employing various mixes of value and growth strategies. Global funds usually also invest a small percentage of assets in emerging markets.

Regional - funds of this type invest in targeted global regions. Diversification is lower and volatility is higher compared to broader-based international funds. Long-term capital appreciation is the primary objective.
  • Europe - invests at least 75% of assets in Europe, primarily in established markets.
  • Diversified Pacific/Asia - invests at least 75% of assets in Pacific/Asia markets, primarily in established markets.
  • Pacific/Asia ex-Japan - same as above, except these funds do not invest in Japan.
  • Latin America - invests at least 75% of assets in Latin America, all of which is classified as underdeveloped markets.

Emerging Markets - these funds invest in economically underdeveloped countries. Volatility and risk can range from high to very high. Long-term capital appreciation is the objective.

Single Country - funds of this type target one specific country, which may be either established or emerging in economic development. Diversification is very low; volatility and risk can range from above average to very high. Long-term capital appreciation is the primary objective.

Frontier Markets - these funds invest in extremely underdeveloped countries and have the highest risk of all foreign fund categories. Long-term capital appreciation is the objective.

 Foreign Allocation Guidelines 

With so many different types of foreign fund categories, where does an investor start? The fundamentals of effective diversification - the spreading of assets over diverse and distinct fund categories to achieve (1) specific risk/reward objectives and (2) a reduction of overall portfolio risk - should remain the cornerstone of investment strategy. With this in mind, the choices for foreign allocation is largely dependent upon (1) portfolio size and (2) individual risk tolerance.

The size of one's portfolio will determine the number of foreign funds: the larger the portfolio, the number of  different types of foreign funds can increase to provide greater diversification.

Risk tolerance is also a significant factor in not only the number of funds, but also in the selection of different types of foreign funds: generally, the higher the individual tolerance for risk, the greater number of differing foreign fund types are available and appropriate for the portfolio.

How to qualify risk tolerance? Conservative risk tolerances will accept lower returns to minimize price volatility. Moderate, or average, risk tolerances will accept greater price volatility than conservative risk tolerances to pursue higher returns. Aggressive risk tolerances will accept large swings in price volatility to seek the highest returns. In addition, currency valuations and political stability are additional risk factors to consider when choosing foreign funds.

 Foreign Allocation Suggestions 

The following foreign allocation suggestions assume a long-term, growth-oriented return objective strategy. Note: As investors approach retirement and if the growth-oriented asset strategy changes to one of a balance-oriented or income-oriented asset strategy, then investors should scale back on these foreign allocations.

For conservative risk tolerances, the foreign equity allocation can range from 10-15% of the overall portfolio. Either a global, foreign large value, or foreign large blend fund would be appropriate. If the size of the portfolio is over $75,000, then a second fund, a foreign mid/small value, could be added to enhance return and diversification; however, this second fund should be no greater than one-third the size of the first fund. Regional, emerging market, single country and frontier foreign fund categories are inappropriate for a conservative risk tolerance.

For moderate risk tolerances, the foreign equity allocation can range from 15-25% of the overall portfolio. Either a foreign large value or blend would be appropriate for a core international fund. With larger portfolio sizes of over $100,000, a second and possibly a third fund could be added -- these second and third foreign funds should total no greater than one-third the size of the first fund. The second and, if chosen, third fund could choose from the following categories: foreign small/mid value, regional and, to a much lesser degree, emerging markets. The single country and frontier foreign fund categories are inappropriate for a moderate risk tolerance.

For aggressive risk tolerances, the foreign equity allocation can range from 20-35% of the overall portfolio. A foreign large blend or growth would be appropriate for a core international fund. With larger portfolio sizes of over $100,000, a second, third, and possibly a fourth fund could be added -- these second, third and fourth foreign funds should total no greater than one-half the size of the core fund -- these additional funds could choose from foreign small/mid value or growth, emerging markets, and to a lesser degree, single country funds. Note: an alternative strategy for one foreign core holding is to choose two regional funds such as Europe with Asia/Pacific or Pacific/Asia ex-Japan to achieve desired allocation percentages for these two funds (e.g., 60/40, 55/45, 40/60, etc.).

Investors should realistically evaluate their tolerance for risk on a regular basis. In my opinion, many investors initially take overly excessive risk, only to realize their mistake when significant negative losses occur. Be deliberate and realistic when assessing your individual risk tolerance. If a sizable loss would adversely affect your long-term viewpoint, then (1) descend to the next lower level of risk tolerance, (2) select less risky foreign fund categories or (3) choose lower allocation percentages in existing fund categories.

Finally, once an investor has chosen the appropriate foreign fund categories, the next step involves selecting specific funds. Select no-load funds with above-average category performance, objective and style adherence, preferably long-tenured management and average to below-average operating expenses for each particular fund category.