Last Updated Feb 10, 2010 11:55 AM EST

The way the stocks are moving, the name emerging markets sounds like an understatement. Investors are reaping huge returns in nations such as China, up 69 percent so far this year; India, up 39 percent; and Brazil, up 31 percent. Intrepid portfolio managers who ventured into the Peruvian market in January doubled their stake in six months. Maybe we should rename them the breakout markets. It should come as no surprise, given recent returns, that mutual funds buying stocks on these foreign exchanges saw inflows of $4.9 billion during the first five months of 2009.

So should you jump in as well? No. Wade in slowly, perhaps. But dont jump. While there are plenty of good reasons to invest more of your money abroad than you probably do now, the recent performance of the Peruvian Bolsa de Valores de Lima is not one of them. These markets can move against you quickly: The MSCI Emerging Markets index, for example, was down 54 percent last year.

The standard advice is to keep 10 percent to 25 percent of your total portfolio invested abroad, and this years emerging markets surge is a reminder of why thats a good idea. The U.S. hardly has a monopoly on economic opportunity measured crudely by the market value of publicly traded stocks, the U.S. accounts for about 45 percent of the worlds corporate wealth. Why expose your portfolio to less than half of the global economy? In addition, so many dollars are being printed by the Federal Reserve to battle the recession that anyone who believes in the law of supply and demand has to wonder whether the greenback can hold its value. In such an environment, trading some of your greenbacks for assets denominated in other currencies isnt exotic; its just financial prudence. True, owning foreign stocks would not have saved you from the great crash of 2008 world markets joined hands and jumped off the cliff together last year. (In fact, the S&P 500 did a little less horribly than the MSCI EAFE index.) But in the long run, markets abroad have tended to zig when U.S. markets zagged. That has happened often enough that portfolios owning both U.S. and foreign stocks have been more stable than those owning U.S. stocks alone. And theyve had a slightly better return. Cant beat that.

Heres a three-step plan for wading into international waters.

1. Determine the Right Amount of Foreign Exposure

International investing, especially in emerging markets, can be volatile, so the appropriate asset allocation depends largely on your time horizon and ability to handle losses. The younger you are, the more time your investments have to rebound from temporary downturns and, therefore, the more you can afford to commit overseas.

Although keeping as much as 20 percent of your stock portfolio in international equities is a good rule of thumb, brave young investors willing to endure sharp swings in their returns could hold up to 30 percent. You shouldnt go much higher, because of the currency risks and political risks that come from investing overseas, says Alec Young, international equity strategist for Standard & Poors. To get a sense of what the appropriate weighting might be for you, check out this asset allocation calculator.

2. Spread Your Wealth around the Globe

The best way to start building an overseas portfolio is to buy a low-cost, broadly diversified international index fund. Its tough to beat the Vanguard Total International Stock Index Fund (VGTSX ). The portfolio provides exposure to both emerging markets and developed regions, and its expense ratio a meager 0.34 percent is a fraction of what youd pay for most international stock funds. A similar offering without the emerging markets exposure is the Vanguard Developed Markets Index Fund (VDMIX ). Both funds have a minimum investment of $3,000.

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Another investment option is an exchange-traded fund that tracks an international index. Like a mutual fund, an ETF is a basket of stocks. But unlike a fund, you can buy or sell it anytime during the trading day and theres no minimum investment. Youll also pay a transaction fee, which you generally do not when buying a fund. Vanguards awkwardly named FTSE All-World ex-US ETF (VEU ) holds a portfolio similar to that of the Total International Fund, though it includes even more countries. (Youll get Canadian exposure in the ETF, but not in the fund. Go figure.)

When investing abroad, keep in mind one distinction: International funds tend to invest all their cash outside the U.S. while global funds are, well, global, so they are likely to own shares in American companies. If your goal is geographical diversity and you already own U.S. stocks, stick to the international funds.

Purchasing individual foreign stocks is riskier than buying a fund or an ETF, since success depends on your ability to correctly analyze both particular companies and the countries where they are based.

To hedge or not to hedge: While some international funds hedge their currency exposure through futures contracts, hoping to protect returns when foreign currencies lose value against the dollar, youre better off sticking with unhedged funds. For one thing, a key reason to invest internationally is to have some money in currencies that will go up when the dollar goes down. For another, hedging typically drives up the cost of your fund. Youre going to pay more, and most managers also tend to not hedge at the right time, says S&Ps Young. These two unhedged funds have beaten the standard international stock index over the past 10 years and have reasonable expense ratios and no sales charge: USAA International (USIFX ) and Scout International (UMBWX ).

3. Boost Potential Gains by Spicing Up the Mix

Scores of academic studies have shown that most mutual fund managers cant beat the index over the long term. That said, some funds do have a track record of outperforming. If you want to try to pick those managers, its best to do so only after establishing a core portfolio of index funds. That way youll capture the markets returns and then, if your actively managed funds outperform, your portfolio will get an extra boost. If they lag, it wont hurt your overall performance too much. Two good options:

• Artisan International Value (ARTKX ), run by David Samra and Daniel OKeefe, dubbed Morningstars International-Stock Fund Managers of the Year for 2008. This fund owns a concentrated portfolio of 50 or so stocks trading at deep discounts compared with what Samra and OKeefe think they are really worth. Since its inception in 2002, the fund has had an average annual return of about 14 percent, compared with the EAFE indexs 8.5 percent.
• Masters Select International (MSILX ) run by several top money managers, including Oakmark Internationals David Herro and Third Avenue International Values Amit Wadhwaney. Though the fund took a pounding in 2008 (down 45.5 percent), it has posted a 5.9 percent average annual return over the past five years. Masters Select currently has 32 percent of its funds in Asia and 36 percent in Europe, while the Artisan managers have invested 62 percent of the fund in Europe and just 22 percent in Asia.

As you build your international portfolio, large diversified foreign funds should make up about 80 percent of your holdings leaving the remaining 20 percent for riskier funds specializing in emerging markets, specific countries, or foreign small-cap stocks.

Resist the temptation to bet the house on the hot performers. With the average diversified emerging markets fund up a staggering 33 percent this year, its tempting to load up on such funds, but remember that they can go down just as fast. These markets move really quickly, says Jason White, a portfolio specialist at T. Rowe Price. Its best to only buy something you can live with for a while. When venturing into these riskier asset classes, start with a small bet, add to it over time, and plan to hold on. Allyn Donaubauer, a Merrill Lynch financial adviser in Fort Smith, Ark. limits his clients exposure to emerging markets to 10 percent of their foreign portfolios.

For more diversification, you may want to buy an international bond fund. Just as foreign stocks can smooth your overall returns by going up when other assets are going down, foreign bond markets often move to a separate beat as well. As with foreign stocks, non-U.S. bonds provide foreign currency exposure. Whats more, you might get higher interest payments in foreign lands. The Templeton Global Bond Fund (TPINX ) is a top performer, with a 10-year average annual return of 9.6 percent. Veteran manager Michael Hasenstab has a value-oriented approach, investing only in countries with strong growth potential where bonds seem underpriced. And despite the global name, his top 25 holdings are all foreign.

Peru, however, is not represented.

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