Five Steps for Finding Your First Foreign Fund

But what if you don't own any foreign funds? Is it too late to join the party? And what type of foreign fund should you look for? Here are some of the key considerations to bear in mind when adding international exposure to your portfolio.

Step 1: Get a plan
Before you set about selecting a foreign fund, first consider why you want to invest overseas. Are you simply chasing foreign-stock funds' strong recent gains? If so, remember that basing your portfolio decisions strictly on past performance is often a recipe for disaster, as once-hot categories can cool off just as quickly as they heated up.

And even if you determine that you're buying a foreign fund for the long haul, it still pays to ask yourself what you're hoping to gain from it. Are you looking for a sturdy core fund that provides exposure to great foreign companies such as Toyota (NYSE: - ) and Nestle (Other OTC: - )? Or are you instead looking for diversification--to fill a hole in your portfolio with a type of security that will zig while your other holdings are zagging?

Knowing why you're investing overseas will go a long way toward helping you select the best fund (or funds) and sticking with that choice. In years past, many investors bought foreign funds with the assumption that they would automatically provide diversification and, in turn, lower their portfolio's risk level. In hindsight, however, that was far too simplistic an argument, largely because there's just as much variation in foreign funds as there is in U.S.-based offerings. Yes, some foreign-stock funds have exhibited a performance pattern that's quite different from the U.S. large-company stocks; foreign funds that focus on smaller companies or those that buy heavily into emerging markets are a case in point. At the same time, however, other foreign funds have--unnervingly enough--tended to behave much like U.S.-stock funds.

In the end, the best reason to own a foreign fund may well be because it provides exposure to the many high-quality companies domiciled overseas, not for protection when the going gets rough in the U.S. market. But if you are explicitly seeking diversification, knowing that at the outset can help you home in on those funds best equipped to deliver it.

Step 2: Determine the appropriate allocation for you.
We can't stress enough the role that asset allocation plays in the overall success of your portfolio helping you to achieve your goals. While it's true that ballpark figures provide a helpful reference point, in reality it's tough to come up with one-size-fits-all recommendations. Again, if you haven't read last week's The Short Answer by Chris Davis, now is the time to do so.

For a more precise read on how much to stake in foreign stocks, check out the Morningstar Asset Allocator tool, which shows you your optimal asset allocation, including a target foreign stake, based on your time horizon and savings level. (Asset Allocator is free to Premium Members of Morningstar.com; click here for a free trial.)

Step 3: Identify the right fund(s) for you.
Once you've determined your target allocation, turn your attention to determining the type of fund that best suits your goals. (Refer back to Step 1.)

If you're seeking a core foreign-stock fund because it provides exposure to high-quality global companies, your best bet is to look for those offerings that hail from Morningstar's foreign large-cap categories. True, such funds may tend to behave a lot like U.S.-focused large-cap offerings. But foreign large-cap funds tend to be well diversified across regions and sectors; many also include a smattering of high-growth emerging-markets stocks. And as in the U.S., foreign large-cap offerings have tended to lag smaller-cap-focused funds over the past several years, potentially giving them more near-term upside potential than their smaller-cap counterparts might have. Finally, the large-cap space is home to some of the best overseas stock-pickers, with luminaries such as Mark Yockey (Artisan International (NASDAQ: - )) and Hakan Castegren (Harbor International (NASDAQ: - )) running topnotch large-cap offerings.

If, on the other hand, you're looking for a second international fund or want your primary foreign fund to provide diversification away from your U.S.-based portfolio, you might look to Morningstar's foreign small/mid-value or foreign small/mid-growth groups. Such offerings will tend to be more volatile than their large-cap counterparts--and can thus be harder to live with in downturns. But as their recent winning streak indicates, they also offer significant return potential for long-term investors.

The Morningstar Fund Screener and Premium Fund Screener provide an easy way to identify the ideal foreign funds for your needs; Premium Members can click here for a look at a screen that I ran. You'll notice that I didn't screen on three-year performance but rather looked to funds that have performed well over longer time periods.

If you'd rather that our analysts did the heavy lifting when it comes to selecting funds, check out Morningstar's Fund Analyst Picks for a lineup of the best and brightest foreign funds available today. (Unlimited access to our list of Analyst Picks is another feature of Morningstar.com Premium Membership.)

Step 4: Avoid niche players.
You'll notice that the preceding step didn't mention emerging-markets funds, offerings that focus on a single region, or single-country funds. That was a conscious choice, not an oversight. Yes, some of these niche funds have been tearing up the charts lately. (Note to those lucky enough to have bought an Eastern Europe fund five years ago: Enjoy your retirement.) But these funds tend to be expensive, and their volatility has also been extreme, prompting many investors to buy and sell at inopportune times.

Better-diversified foreign-stock funds may not offer the potential for huge gains from a single region when it's hot, but they can and will take advantage of attractive opportunities in smaller markets. More importantly, they can get out when a particular country's or region's markets turn sour. Diversified emerging-markets funds may make sense for investors with large portfolios, but most investors simply don't need regional or single-country funds at all.

Step 5: Be a savvy purchaser.
As any of Morningstar's international-fund analysts will tell you, the popularity of foreign investing tends to wax and wane with these funds' performance, and many investors have historically timed their purchases poorly. Foreign funds--and emerging-markets funds in particular--attracted scads of new money following their runup in 1993, for example, only to endure a huge sell-off the following year.

No one is saying that foreign-stock funds are due for an imminent crash, despite some turbulence in emerging markets and Japan earlier this year. But rest assured that foreign stocks' trajectory won't be straight up, so if you're buying an international fund right now, plan on making a long-term commitment to it.

You might also consider using a dollar-cost averaging plan, whereby you invest smaller sums at regular intervals (say, every month) rather than putting a lump sum to work in the market right away. That's a particularly wise strategy if you're considering a fund from one of the groups that has performed particularly well over the past few years, such as the foreign small/mid-value category.

A version of this article appeared Sept. 5, 2006.

Christine Benz does not own shares in any of the securities mentioned above.