Investing abroad used to pay off better

— -- U.S. investors have been sending their money abroad for the past several years. When that money has returned, investors have been able to boast about their savoir faire and elan.

This year, however, U.S. investors have been yelling, "Sacre bleu!" and "Zut!" What investors have forgotten is that investing abroad isn't always a cure for U.S. stock market malaise.

The past five years, investors have poured a net $372 billion into diversified international funds, according to Lipper, which tracks the funds. To put that in perspective, it's more than two and a half times the value of all the gold in Fort Knox at today's prices.

For much of the past five years, investors have been amply rewarded for shipping their money abroad. The Lipper International Fund index has soared 164% in the past five years, vs. 70% for the Standard & Poor's 500-stock index. This year, the results have not been quite as happy. The S&P has fallen 6.5% this year, vs. 5% for the Lipper International Fund index. What gives?

International funds need two things to clobber U.S. stock funds. The first, and more important factor, is good returns from abroad. And most countries' stock markets have fared very well the past five years.

The German stock market, for example, has gained an average 16.5% a year since April 2003, according to MSCI Barra, which tracks foreign markets. The Australian market has soared an average 13.9% a year. In contrast, the S&P 500 has gained an average 11.2% a year the past five years.

Currency is the second. The falling dollar has turbocharged foreign investments. When the dollar declines in value, international investments rise. Think of it this way: Suppose you had bought 1,000 euros five years ago, and stuffed them in a safety deposit box in the Banque de Blancmange. Back then, a euro was worth $1.09, so you'd have spent $1,090.

Today, however, a euro is worth $1.59. Were you to open your safety deposit box and convert your euros to dollars, you'd have $1,590 — a 46% gain.

Combining hot stock markets with a tumbling dollar makes for very happy returns indeed. For example, we'd mentioned earlier that the German stock market gained an average 16.5% a year. That's measured in euros. When converted into U.S. dollars, the German market has soared 25.9% a year.

Clearly, then, the best time to buy an international fund is when foreign markets are booming and the dollar is crawling into the cellar. And that pretty well describes the past five years.

Unfortunately, the next five years may not be quite as good. The European economy has been slowing, and S&P expects Euro-zone earnings to slow, too. Lower earnings augur lower stock prices. Thursday, Finnish cellphone maker Nokia offered gloomy earnings guidance; the stock fell more than 14%.

European stocks account for about half of all foreign funds' portfolios, says Alec Young, international equity analyst at S&P. Should Europe falter, international funds will feel the pain.

What about the dollar? By one measure, the dollar is already undervalued. According to economic theory, common, identical items should cost about the same in different countries. Any difference in price between, say, England and the USA would be because one country's currency is over- or undervalued.

To test the theory, The Economist magazine created the Big Mac index, which measures the price of McDonald's famous burger in various countries. A Big Mac in the euro zone cost $4.17, vs. $3.41 here — and that was back in July, when the index was last updated. At today's conversion rate, a Big Mac costing the same 3.02 euros it did in July would cost $4.87, suggesting that the dollar is undervalued.

On a more concrete basis, the dollar tends to rise and fall according to differences in international interest rates. Money flows to the country with the highest rates. Currently, the U.S. fed funds rate, the key overnight loan rate, is 2.25%. The European Central Bank's equivalent rate is 4%. Not surprisingly, investors are selling dollar-denominated investments and heading to Europe.

Should the European economy slow, however, the ECB will eventually cut rates — and that could mean a rally in the dollar. The upshot could be a double whammy for international fund investors: lower stock prices and a higher dollar.

What's an investor to do? First, don't sell all your international funds. They're a good diversifier over the long run. As a general rule, you should keep 10% to 20% of your portfolio in international funds.

On the other hand, if you had set a target of, say, 15% of your portfolio in international stocks, you're probably somewhat out of balance now. You might consider trimming back your international fund holdings closer to your goal.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.