Too Much Emphasis On Foreign Investment?

Includes: EEM, EFA
by: Richard Shaw

US investors have been piling into foreign investment in the last few years. This raises the question: “Is foreign investment overemphasized?”

We read through Investment Company Institute statistics footnotes and got some help form ICI staff to fill in the blanks concerning the flow of investments into and out of mutual funds by classification as domestic [US] or non-domestic [World or International] funds. The results are dramatic.

As the chart below shows, in the first 11 months of 2006 5 times as much net money flowed into non-domestic funds as domestic funds. If we include December 2005 for a 12-month figure, we see 6 times as much net money going into non-domestic funds.

Just as a too fast or too extended high rate of change of an individual security price tends to indicate a coming trend reversal, we think too fast and too long an imbalance of fund inflows to non-domestic funds is an indicator of a coming trend reversal.

Given that most advisors recommend between 10% and 20% non-domestic allocation in a stock portfolio, how long can inflows to the non-domestic category be 5+ times as great as domestic inflows? Clearly, during a catch-up in allocations the imbalance can continue, but not after prevailing allocation recommendations are reached. That time may be sooner than later.

Over the past 5 years (actually 59 months), the total net inflows to mutual funds have been $586 billion. Of that, 56% of inflows have been to non-domestic funds and only 44% to domestic funds. How long can that ratio persist before non-domestic allocation targets are met?

According to the 2006 Investment Company Fact Book, at the end of 2005 non-domestic stock fund assets represented 10% of $8.9 trillion in mutual fund assets (including money market and bond funds) and domestic stock funds held 45%. That means that non-domestic funds accounted for 18% of all stock mutual funds (10 divided by 55).

As of November 30, 2006 total stock fund assets of US registered funds was $5.86 trillion and net inflows to non-domestic funds were $12.3 billion, or about 2% of total stock funds. Putting a 2% net inflow in 2006 together with a 10% non-domestic allocation in 2005, we predict something like a 12% non-domestic allocation report in the 2007 Investment Company Fact Book.

So how much more money can flow into non-domestic funds? The current allocation of 12% just might be near the top. If the average fund holder is moving toward a 15% allocation, we might see one more strong year of non-domestic inflows followed by significant moderation or decline in 2008.

The key observation is that the dramatic inflow to non-domestic funds is providing uplift to non-domestic stocks. When allocation targets are met and the absolute number of dollars flowing into non-domestic funds falls, the former uplift will be removed and non-domestic stocks will tend to decline. Declines, just like gains, tend to perpetuate themselves for a while as momentum investors follow and reinforce directional movement.

We think the non-domestic basket is about full. As a result, we are feeling cautious about non-domestic assets based on money flow findings such as these.

Related ETFs: iShares MSCI EAFE (NYSEARCA:EFA), iShares MSCI Emerg Mkts (NYSEARCA:EEM)