Investing: Know the ins and outs of international funds

— -- Someday soon, according to a recent filing at the Securities and Exchange Commission, you'll be able to buy shares of the Market Vectors Indonesian Small-Cap ETF.

Should anyone suggest you buy this fund, which invests in the stocks of small Indonesian companies, it would be perfectly permissible to call him a clown and hit him in the face with a pie.

What if someone suggests you invest in a large, diversified international fund? You should refrain from hurling invective (and baked goods). But you don't absolutely need an international fund, either.

You can make two good arguments for international funds. First, the U.S. isn't the only country on the planet with a stock market. When you buy U.S. stock funds, you miss the opportunity to invest in companies headquartered abroad, and some of them are corkers.

Second, not all markets move in lockstep. By owning shares traded elsewhere, you can own stocks that rise when U.S. stocks fall.

The past decade, the Lipper Large-company Core index has gained 23%, according to Lipper. (Mutual-fund-to-English translation: Large-company core funds invest in the stocks of big companies with reasonable prices, relative to earnings. The Lipper index measures the performance of the largest of these funds.)

The Lipper International Fund index has gained 76% during the same period. A portfolio of 70% U.S. stocks and 30% international stocks would have gained 38.9%.

Not bad, at least compared with an all-U.S. portfolio.

But if you were looking for some love from international funds this year, well, you'd be out of luck. Large-cap U.S. funds have fallen 4.1%, vs. a 10.3% plunge for international funds.

If the record of adding international funds to a portfolio seems spotty, it's because it is. One big reason is that, in recent years, stocks of developed nations have tended to move in harmony, at least when they're moving down: When Wall Street falls apart, so do London and Tokyo.

The past three years, moves in the S&P 500 have accounted for about 89% of the moves in the EAFE index, according to Lipper.

Much of the remaining differential could be because of the currency effect. When the U.S. dollar falls in value, as it has from February 2002 to now, overseas holdings increase in value.

For example: Suppose you bought 1,000 euros 10 years ago, in August 2001. One euro equaled 90.9 U.S. cents. A decade later, a Euro fetched $1.45. Your Euro holdings would have gained 59%, thanks to the currency effect.

Had the euro gone the other way, of course, you would have lost money. And, thanks to the European debt crisis, the euro has started to lose ground to the dollar in recent days. The only real surprise is that it hasn't fallen further.

So to get real outperformance from a foreign fund, you'd need a period when foreign markets are up and the U.S. dollar is down. This happens, but it throws an additional layer of risk onto a stock investment, which is already risky enough for most people.

Nevertheless, it's hard to argue against increased diversification, even if it's of marginal value. So what should you look for in an international fund?

•Broad diversification. If you're Indonesian, then, sure, take a flyer on the Indonesian Small-Cap fund. Otherwise, avoid single-country funds and regional funds.

•Low expenses. International funds tend to have somewhat higher expenses than U.S. funds, but that doesn't mean you have to pay too much for them. The average international core fund charges $15.50 per $1,000 invested, or 1.55%. Look for something cheaper.

If you're an index fan, you can simply buy iShares MSCI EAFE Index, an exchange traded fund that trades on the New York Stock Exchange under the ticker (EFA) and has a 0.35% expense ratio. Vanguard Total International Stock Index fund (VGTSX), which you buy directly from the company, has an even lower 0.26% expense ratio.

•A good record. Good past performance doesn't mean a fund will perform well in the future. But rotten funds often stay rotten.

The international large-company blend funds in the chart all have above-average performance, and below-average expenses. And they're widely diversified, too — which is probably their biggest benefit.
