Mutual fund investors taking another look at international investing after last year's drubbing face the difficult question of where in the world to place their chips.
Many diversified international funds pursue a bottom-up, stock-picking approach, which requires fund managers to rack up serious frequent-flier miles as they kick the tires of companies around the globe. Others follow the more passive strategy of simply purchasing a representative basket of stocks in each country of interest.
In both cases, fund managers usually weight their portfolios country-by-country against a benchmark that reflects the size of each country's stock market. The most popular benchmark for weighting an international portfolio of developed-country stocks is the Europe Australia Far East (EAFE) index published by Morgan Stanley Capital International. The EAFE index represents 20 major equity markets, ranked by the total value of the stocks traded in those markets.
Buying a fund that reflects the EAFE index or some portion of the index seems like a straightforward way of gaining investment exposure to major non-U.S. stock markets, just as buying a Standard & Poor's 500 index fund equates to buying the U.S. stock market.
But many investors have never heard of the EAFE index. And there's no strategic reason to own foreign stocks strictly in proportion to their stock markets' share of total world tradable equity.
For example, Japan's is a huge stock market, but international funds holding the EAFE weighting of Japanese stocks performed poorly in recent years because of that nation's economic and stock market malaise.
Joseph Keating, chief investment officer for the Kent Funds in Grand Rapids, Mich., believes that the market capitalization approach to apportioning international investments has the same problem that afflicts buyers of the S&P 500 index.
Because of the market-cap weighting, putting money into the S&P 500 index rewards the bigger stocks in the index more than the smaller stocks and leads to distortions in stock valuations.
Similarly, mimicking the EAFE index from the mid-1970s to early 1990 would have exposed investors to the disastrous Japanese stock market bubble, which deflated by 50 percent in subsequent years.
"Index funds have this built-in momentum bias," Keating said. "I was very uncomfortable with that. Because of the momentum you're buying in [past] winners and underweighting losers," which can lead to horrendous market timing.
As an alternative, country exposures in the Kent International Growth Fund are weighted according to the gross domestic product of the countries in the EAFE index, not stock market capitalizations.
Although a nation's stock market and its GDP should move in the same direction over time, a snapshot of 20 GDPs and 20 stock market capitalizations denotes different weightings.
For example, Keating said, the market capitalization of stocks in the Netherlands equals 6 percent of the EAFE index, but the country represents only 3 percent of world GDP. On the other hand, Germany's economy represents 17 percent of world GDP but its stock market constitutes 10 percent of the EAFE index.
Placing your international chips by relative GDP size avoids the problem of chasing overpriced stocks and overpriced stock markets, Keating maintains.
In a different approach, Brian Cerini, president of LMI Capital Management in Pasadena, Calif., is offering a series of international equity index funds that mimic the best-known stock market indexes in each of 11 major countries.
His firm also sponsors a European fund consisting of eight popular European stock market indexes and an international fund consisting of all 11 country indexes. For the European fund and international fund, each country is assigned an equal market-cap weighting, Cerini explained. For example, Spain's weight is equal to Japan's in the international fund, although Spain's stock market is much smaller.
He said professional investment managers suggested this approach. They wanted to use the LMI International Index Fund as a core holding around which to add other country-specific or regional funds.
But equal weighting had a fortuitous consequence in the fourth quarter. Not only did the individual LMI funds for Italy and Spain outperform other European funds, but LMI's consolidated Europe and international funds also benefited by the relatively heavy emphasis on these countries.
Pub Date: 2/28/99