Homeland insecurity: Americans reject U.S. stocks but crave overseas issues

At best, stocks of some of the biggest American companies can’t elicit more than stifled yawns from individual U.S. investors this year.

If people have cash to put to work in equities, they’d rather have something from a far-off shore — say, Chinese telecom giant China Mobile, Russian natural gas titan Gazprom or South Korea’s Samsung Electronics Co.

All three of those companies are among the largest stockholdings of the Vanguard Emerging Markets exchange-traded fund, which in July raked in $2.2billion in fresh cash from investors, boosting total assets to $29.3 billion.

That made it the most popular mutual fund of all for the month, exceeding even the cash intake of bond-fund behemoth Pimco Total Return.

It’s hard to separate hot-money players from buy-and-hold investors in the funds, but the Vanguard portfolio’s chart-topping appeal helps illustrate Americans’ bifurcated view of equities these days: They want less and less to do with domestic stocks, yet they’re happy to hold on to foreign shares or to raise their stakes in those issues.

Many professional investment advisors have been feeding that trend over the last few years by ratcheting-up clients’ overseas stock holdings at the expense of their U.S. holdings. Some advisors now keep at least 50% of their clients’ total equity investment in foreign issues.

Just a decade ago having 25% of your stock portfolio in foreign shares was considered the upper limit.

At this point everyone knows the conventional wisdom about foreign markets, which is that you have to be there in a big way because that’s where the fastest economic growth is likely to be — not in the U.S.

Another lure is that owning assets denominated in foreign currencies should help protect your purchasing power if the dollar’s value wastes away. That was a major factor in foreign markets’ hot performance from 2003 through 2007.

Conveniently, the argument for investing more overseas also fits with America’s grim self-appraisal amid the devastated housing market, sky-high unemployment and record federal borrowing. If you believe that the country’s problems are overwhelming, it’s easy to imagine that things must be better almost anywhere else.

Giles Almond, head of Matrix Wealth Advisors in Charlotte, N.C., says he has been stunned this year by the number of clients who’ve asked him about the merits of moving to Costa Rica, or how they’d go about getting their assets out of the U.S. altogether.

“You could look at it as a contrarian indicator,� Almond says: Extremely negative sentiment about any market often means that’s a good place to look for bargains.

Yet mutual fund investors have continued to chisel away at their domestic equity holdings in favor of sending cash abroad. Domestic stock funds suffered a net outflow of $29.5 billion in the first seven months of this year while foreign funds took in $28.1 billion in new money in that same period, according to the Investment Company Institute.

As they turn their backs on American shares, U.S. investors seem willing to cut foreign markets substantial slack. It was, after all, the European government debt crisis, sparked by Greece’s financial woes, that triggered the spring rout in markets worldwide. Yet domestic funds still bore the brunt of the selling in that slide.

Reality check: Investors who own the most popular foreign stock funds may not be aware of just how heavily skewed their fund assets are to European and Japanese shares, rather than to sexier emerging-market issues. The biggest funds tend to own the biggest stocks, and those issues are in developed markets.

Norm Boone, a principal at Mosaic Financial Partners in San Francisco, figures many people naturally focus less on the day-to-day economic news from abroad while hanging on every negative headline about the domestic economy.

“What you don’t know doesn’t scare you as much as what you do know,� he says.

Investors’ push into foreign equities also has momentum going for it. The tide turned in favor of overseas shares in 2005 and hasn’t let up. Nobody wants to leave a good party.

The late-1990s and early-2000s were dismal stretches for many foreign markets. Asia suffered a major financial crisis in 1997, Russia defaulted on its debt in 1998 and a surging dollar from 1995 to 2002 slashed the returns U.S. investors earned on overseas securities.

But all of that was the perfect set-up for a rebound in depressed foreign stocks beginning in 2003. What’s more, the Chinese economy’s ascendance began to provide a huge lift to many other emerging-market economies by stoking robust demand for their raw materials. And the dollar started to slide, automatically enhancing returns on foreign securities.

Once overseas markets began to outperform U.S. stocks, it didn’t take long for American investors to notice. The idea of global diversification, which fell on deaf ears in the 1990s, suddenly was widely embraced by 2005. That was the year that net cash inflows to foreign mutual funds began to exceed inflows to domestic funds, a shift that has continued every year since.

Both domestic and foreign funds suffered outflows during the global market crash of 2008. But in 2009 inflows resumed to foreign funds even as domestic funds continued to bleed.

While investors could be accused of chasing performance in overseas stocks for most of the last eight years, average returns on foreign mutual funds this year are running about even with U.S. funds — which is to say, pretty dull. Both broad categories were up less than 1% year to date, on average, through Thursday, according to data tracker Reuters/Lipper.

Among specific sectors, though, emerging markets continue to shine. The average emerging-market fund is up about 4.7% this year.

Americans’ continued eagerness to send money abroad may reflect that many believe they still have too little of their assets in foreign shares even after years of increasing their stakes.

U.S. stocks now account for about 32% of total world stock market capitalization, according to Goldman Sachs & Co. To put it another way, 68% of global stock market capitalization is outside the U.S., a dramatic increase from 20 years ago.

That’s obviously the best case for raising the portion of stock portfolios devoted to foreign issues: There are more equity opportunities to tap into abroad — although quantity doesn’t necessarily equal quality.

Almond says his clients’ equity holdings are 35% foreign and 65% domestic, compared with a 25%/75% split two years ago. He expects the foreign portion to continue rising.

Boone has gone to a 50-50 split. “Part of what you’re betting on is that the dollar is going lower,� he said. That would boost the value of foreign assets held in rising currencies.

Steve Lockshin, head of Convergent Wealth Advisors in West Los Angeles, says his clients can be as much as 60% in foreign equities. The idea of maintaining “home-country bias� in a portfolio is simply outdated, he said.

The trade-off in the hunt for higher returns abroad is that smaller foreign markets can be far more volatile than the U.S. market. Studies by Vanguard Group have shown that raising foreign equity holdings beyond 40% of a portfolio produces higher volatility and lower overall returns, said Fran Kinniry, a member of Vanguard’s investment strategy team.

“Between 20% and 40% we think is the sweet spot for foreign allocation� in terms of raising returns while reducing volatility, he said.

Kinniry said Vanguard fears that U.S. investors have become overly enamored of emerging markets, in particular, after their spectacular performance of the last decade. The average emerging-market fund has gained 12.3% a year over the last 10 years, while the average U.S. stock fund has eked out a barely positive return of 0.6% a year.

“We say [investors should] continue to hold emerging markets, but we think people are getting carried away with it,� Kinniry said.

The question isn’t whether emerging-market economies will grow faster than the U.S. and other developed countries, but how much of that extra growth already may be reflected in emerging-market shares.

The U.S. economy, and domestic stocks, are in the exact opposite position: Investors are expecting so little that it may not take much to pleasantly surprise them.

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