With markets soaring last year in places such as India and Turkey, investors poured cash into international funds. Of the $6.6 trillion invested in equity funds, about one quarter is in overseas portfolios, according to the Investment Company Institute. That's a big change from a decade ago, when less than 10 percent of equity assets resided in foreign funds. Are investors overdoing their foreign exposure? No, according to a growing number of financial advisors, who urge investors to put 30 percent to 50 percent of assets abroad.

Many of the new advocates of foreign stocks take issue with the tenets of Modern Portfolio Theory (MPT) pioneered by Harry Markowitz in the 1950s. According to the MPT arguments, investors should put 10 percent to 20 percent of assets abroad. Since the performance of foreign markets does not correlate perfectly with the U.S., international stocks can help to diversify a portfolio, say the Markowitz followers. As the overseas allocation increases from 0 percent to 10 percent, the diversification benefits increase. Risk — as measured by standard deviation — declines. But once the allocation moves from 20 percent upwards to 30 percent, risk stops dropping, the MPT supporters say. Above 40 percent, the risk begins to increase slightly. This occurs because foreign markets — which include emerging markets — have a higher standard deviation than U.S. stocks do. The standard deviation of U.S. markets is 17.5, while the figure for overseas stocks is about 19.5.

Proponents of putting 50 percent abroad speak respectfully of Markowitz. But they argue that MPT has a fatal flaw: It relies on historical data, assuming that future standard deviation will be the same as in the past. “You can never know which countries will perform best going forward,” says Stephen Evanson, CEO of Evanson Asset Management, a registered investment advisor in Carmel, Calif., that clears trades through Schwab Institutional.

Evanson notes that in the first half of the twentieth century, stocks in Germany and Japan produced meager returns. But in the second half of the century, markets in the two countries were among the world leaders. Investors who relied on the rearview mirror missed huge gains. Because the past provides uncertain guidance about the future, Evanson spreads his bets, aiming to about match global-market weightings. At a time when 52 percent of world-market capitalization is abroad, he has about 50 percent of his assets overseas. Why not replicate market weightings exactly? Evanson says that the overseas market cap constantly shifts. “If you rebalance all the time, you may be saddling clients with tax bills, and not doing much to improve results,” Evanson says.

OUTSIZED GAINS OVERSEAS?

Young people may require especially heavy weightings in foreign stocks, says Michele Gambera, chief economist of Ibbotson Associates. Consider a salesman who earns commissions selling American-made cars, he says. “This person's income is correlated to U.S. stocks,” says Gambera. “To diversify risks, the salesman may be better off with a heavy allocation to foreign markets.”

While some advisors accept the argument for big foreign weightings, they are reluctant to put half of assets abroad because of resistance from clients. Older clients especially have fears about investing in “strange” countries, places where corporate names are unfamiliar. Advisors need to recognize the anxieties of clients, says David M. Darst, chief investment strategist for Morgan Stanley's Global Wealth Management group. For the moment, Darst's model portfolio has 33 percent of equities in foreign stocks, with the rest in the U.S. But he plans to slowly increase the foreign allocation. “We have been gradually leading our clients toward greater global allocations,” he says. “You have to educate people, and take them along slowly.”

For clients who fear investing abroad, Darst talks about familiar foreign companies like Nestle, the Swiss giant, and explains how foreign stocks have delivered strong returns over many years. While cautioning clients against chasing hot performance, he argues that emerging markets, such as Brazil, have a bright future.

GO GLOBAL

Besides encouraging clients to increase overseas holdings, some advisors are advocating an approach known as global investing, which differs from standard foreign investing. In the traditional method of foreign investing, a portfolio might have two funds: a foreign specialist and a domestic one. The foreign fund manager might attempt to find the best foreign pharmaceutical companies, while the domestic portfolio would look for U.S. drug companies. In the new style of global investing, the fund manager tries to find the best drug companies in the world, regardless of their location. The global portfolio holds a mix of foreign and domestic stocks, and there is no effort to control the foreign allocation. In an era of blurring international borders, global investing is an efficient way to manage money, argues Timothy Noonan, managing director of Russell Investments, the fund manager and investment advisor. “In global investing, the same analyst who follows GM also watches Mitsubishi,” says Noonan.

In the past year, Russell has been introducing global portfolios to retail and institutional investors. For the time being, many Russell portfolios have 4 percent to 10 percent of their holdings in global portfolios, with the rest in conventional foreign or domestic funds. But Noonan predicts that global funds will gradually become more popular, eventually accounting for half of all foreign holdings. “In the future many managers will be measured against a global index, and not against U.S. or foreign benchmarks,” he says.

Whether Russell's form of global investing takes off, it does seem likely that the amount of assets invested abroad will continue to increase. Noonan says that Canadian and European investors already have big percentages of their assets outside their home markets. Americans may still have a bias toward investing at home, but that could change quickly. “Young Americans are used to consuming global brands,” says Noonan. “It is a short step from consuming a global brand to investing in one.

GOING GLOBAL

Finding the right mix of foreign and domestic stocks.

Morgan Stanley's model portfolios are gradually increasing the allocation to foreign stocks. The current allocation for moderate-risk investors has nearly two-thirds of equities in domestic stocks and the rest overseas.

U.S. Equity
Large Cap Growth 11%
Large Cap Value 11
Mid/Small Cap Growth 4
Mid/Small Cap Value 4
Total U.S. Equity 30
Non-U.S. Equity
Europe 10
Developed Asia 4
Emerging Market 2
Total Non-U.S. Equity 16
Fixed Income 29
Alternative Investments 25
Source: Morgan Stanley Global Wealth Management