Academics and investment planners have pitching the value of international portfolio diversification to individual investors for quite some time now. The last few years have seen a surge in individual asset flows into international equity mutual funds. Undoubtedly the increase in international investment vehicles, like the dozens of ETFs, has made this process all the easier and transparent.

The question is whether this surge in international investment is simply a means of catching up to the commonly recommended 20-40% equity allocation. Or is it simply another case in the long line of individual investors chasing hot performance? We will not know the answer to that question until we have a notable market break, but until then there are plenty of issues to deal with on the international investing front.

Chet Currier at notes the fact that mutual fund investors have put substantially more into global equity funds than domestic equity funds in 2005, 2006 and 2007 year-to-date. That brings allocations up to seemingly “normal” levels.

At last report, by my calculations, the FRC data show world fund assets at 26.5 percent of the total in equity funds. That number doesn’t look excessive if we recall that numerous advisers have long been urging U.S. fund buyers to put 20 percent to 30 percent of our stock money in international funds.

This begs the question as to whether most investors really know what they are getting themselves into. David Merkel at the Aleph Blog notes a handful of “micro” issues that investors should take into account when they invest overseas. In short,

I believe in international diversification; in general it is a good thing. But it should not be done blindly; investors should consider the factors that I have mentioned above, if not more factors.

One area that investors have embraced is the emerging markets. While many will cite the higher growth rates as the attraction of the emerging markets, something else is going on. FT Alphaville cites a Merrill Lynch report on the emerging markets that notes the changing nature of the emerging markets. Now instead of being a source of instability they may now be a ‘safer haven’ in light of an U.S. economic slowdown.

The underlying fundamentals in emerging markets are “superb”, says Merrill: “We continue to believe the asset class is undercapitalised, under-leveraged, under-owned and under-valued.”

So, in a mirror image of 1998, emerging markets are the asset to buy in increasingly frequent bouts of market volatility. Credit problems are now in the US rather than in emerging markets. Liquidity to ease the US credit problem will be redirected toward emerging markets , just as liquidity to ease the Asia/LTCM problems last decade was redirected toward the tech sector.

If that really is the case then not only will the so-called BRIC countries benefit, but frontier markets will as well. Gregg Wolper at reports on how fund managers are adding frontier markets into their portfolios. He notes how most managers divide the emerging markets into tiers with the most established markets at the top with the smaller markets at the bottom.

The fact of the matter is that this process of integrating frontier-type markets into the mainstream has been happening for a long time. The names change, some markets ’emerge’ and then sink back down to ‘frontier’ status while other countries simply become developed. The indices will always be a step or two behind the cutting edge. That is where Wolpper notes an effective manager can add value:

Given that a mutual fund investing in India or Poland might have seemed a radical idea not too long ago, it’s important to recognize that what now seems hopelessly exotic can easily become commonplace. More to the point, if you want your fund to beat the index and outpace rival funds–and it must in order to earn its fees–then you have to allow its manager some freedom to deviate from the index and peers and accept the risks that come with that.

Much has been made about the rising correlation between the U.S. and international markets. (Although there may be some reversal in that trend.) Those higher correlations may mitigate some of the benefits of international diversifcation. Indeed those correlations will change over time. Focusing to closely on those zigs and zags is a mug’s game.

What is more important is the strategic role that international diversification, specifically non-dollar, unhedged exposure may have. We discussed last year when the energy markets were going ballistic that an exposure to commodities, like energy, can serve as a natural hedge of your ongoing energy needs. It would take some fancy math to figure out the exact exposure needed, but it makes intuitive sense that when energy prices rise, your personal expenditures go up, as would the value of any energy investments.

The same “natural hedge” argument* could be made about international investments as well. Even a cursory glance at your expenditures would show significant spending on a number of foreign products. In our minds it makes some sense to ‘hedge’ a (potential) longer term slide in the dollar with some foreign exposure. The amount and nature of that allocation is, of course, up to you.

International investment is by no means a portfolio panacea or a perfect ‘hedge’ by any means. Despite the recent run-up in the world markets there will come a time when the international markets underperform. However a well-conceived notion of why you have diversified your portfolio internationally in the first place, will serve you well in more tumultuous times.

*Dedicated readers of Abnormal Returns will note that we made a similar argument as a part of the Big Picture’s Blogger’s Take on the state of the U.S. dollar.

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