BOSTON — A decade ago, many investors shied away from overseas mutual funds.
Foreign stock markets were too strange, unfamiliar and, well, foreign.
How times have changed.
International funds now post $239 billion in assets, compared with $7 billion in 1987, according to the Investment Company Institute, a fund industry trade group.
A key reason: Investors have been told, again and again, that foreign stocks offer valuable diversification, reducing the risk of your overall portfolio.
The argument goes like this: If you invest some of your money in overseas stock markets, you will be protected if the US market takes a nose dive.
Moreover, some studies show that a portfolio with 30 percent in foreign stocks and 70 percent in American stocks would have delivered higher returns at lower risk than an all-US portfolio during the past 20 years.
But another study, by Birinyi Associates in Greenwich, Conn., finds that foreign markets, on average, move in the same direction as America's 77 percent of the time. Individual markets are above or below that average.
And diversification doesn't always boost total returns.
International funds have gained only about 10 percent annually since 1987, compared with 16 percent for the typical domestic equity fund, according to Lipper Analytical Services.
And Japanese stocks, which tend to move very differently from the US market, have suffered considerable losses throughout the 1990s.
A policy of avoiding Japan has helped many international funds deliver better returns in recent years. But it has made them less useful as diversification tools. In fact, the best-performing overseas funds in recent years have invested largely in markets that follow the US market closely.
Not surprisingly, those have been the most popular overseas funds.
The upshot: Many investors who turn to overseas funds for diversification may be disappointed to find that those funds decline almost as much as domestic stock funds if the US market stumbles.
How can you avoid that problem? Some analysts recommend some recent laggards among international funds. Japan and emerging markets, for example, may be ripe for a comeback (see story, below).
Laggards also include funds that focus on small foreign companies rather than blue-chip multinationals with close ties to the US economy.
Some examples of funds analysts like in these categories:
Templeton Developing Markets (800-292-9293; $100 minimum investment; 5.75 percent load). Manager Mark Mobius is a value-oriented investor, and his picks have delivered solid returns at below-average risk for such funds.
Alternatively, you could focus on a single emerging market. Scudder Latin America (800-225-2470; $2,500 minimum; no load) is a well-regarded offering.
Funds that invest in Japan include T. Rowe Price Japan (800-638-5660; $2,500 minimum; no load). The fund's management team favors large Japanese firms with strong export sales.
Finally, funds that invest in small foreign companies include Templeton Foreign Smaller Companies (800-292-9293; $100 minimum; 4.5 percent load), with a value-oriented approach. The fund performed 35 percent better than the typical foreign stock fund during the past five years, with about 35 percent less volatility.
Even well-chosen foreign funds will likely post modest, short-term losses if US stocks slump. But in the long run, they should reduce the fluctuations in your portfolio.
* Clint Willis, a freelance writer, covers mutual funds for Reuters.