That fund you think focuses on the U.S. may be stuffed with foreign stocks.

By Thomas M. Anderson, April 2006

You may have heard of the tendency of some funds to stray beyond their supposed boundaries — for example, value funds that buy growth stocks and big-company funds that invest in small companies. Nowadays, many domestic stock funds are playing a different version of so-called style drift. They’re raiding Japan, running wild in Canada and hunting for game in India, among other places. Call it cross-border drift.

That managers of ostensibly domestic funds are increasingly looking for greener pastures overseas is no surprise. Over the past three years to February 1, foreign stocks have, on average, outpaced the 16% annualized return of Standard Poor’s 500-stock index by nine percentage points per year. As a result, any U.S. fund that invested heavily in international stocks probably beat the SP index over that period. But just as foreign stocks have enhanced returns lately, they can hurt results once the tide turns.

Mucking up the mix

Another problem with cross-border drift is that it can disrupt a carefully constructed portfolio. If many of your U.S. funds contain overseas stocks, you probably have more invested in foreign stocks than you’d like. ÒAs a practical matter, we wouldn’t like to have any international stock in a domestic fund, but you have to live in the real world, says F. Dennis De Stefano, a financial planner in Maui, Hawaii.

Traditionally, you knew a fund had a big stake in foreign stocks if its name contained a telltale word, such as foreign or global. But many domestic funds are ditching bland local fare for spicy overseas cuisine. Harry Lange, who became manager of Fidelity Magellan last year, has upped the fund’s foreign allotment from 4% to 25%. At last report, five of Magellan’s ten biggest holdings were foreign companies.

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Third Avenue Value has gone further. At last report, it had 42% of assets in foreign stocks, and its largest holding was Toyota. It’s hard to argue with the results. Over the past three years, the fund gained 29% annualized.

Managers of domestic funds say there simply are better opportunities overseas than in the U.S. market. You can buy similar companies cheaper just because they happen to be north of the Canadian border, says David Iben, manager of Nuveen NWQ Value Opportunities, which has about 35% of assets in foreign stocks (see Bounty to the North, on page 52).

Some funds have raised the level they can invest in foreign stocks. In 2004, Franklin Templeton’s Mutual Qualified bumped its target foreign cap from 35% to 50%. Co-manager Anne Gudefin moved to London last year to pursue more opportunities overseas. The fund has done better compared with ones that have invested less in foreign securities, Gudefin says.

The trade-off

Ultimately, investors must decide what matters more: consistency in style and asset allocation or the flexibility to go where the best opportunities are, even if it means a manager is fishing in unfamiliar waters. Investors in Janus Contrarian buy the process of identifying uniquely valued companies anywhere in the world more than an allocation of international versus U.S., says manager David Decker. They also buy a fund with 17% of its holdings in India. Since the fund began in 2000, foreign exposure has grown from about 10% to more than 40%, Decker says.