An inflation shield?

American investors saw stock prices surge last year, peak this winter, and retreat a little this month.

As a result, some anxious investors may be considering alternative investments to the domestic stock market. One intriguing possibility: international stocks.

Most of these funds enjoyed large gains in share prices over the past year. And if the decline in the value of the dollar against other currencies continues, they could benefit again this year. That's one reason why some financial advisers suggest investors move a chunk, but not all, of their portfolio into stocks over-seas.

"Anything that has that big a run-up has an opportunity to turn down again," warns William Roseen, an analyst with Lipper, a mutual fund research firm in New York.

After seeing last year's splendid performance of foreign investments, American investors put more money into international mutual funds in January than in any other month since the peak of the stock market bubble four years ago. That amounted to $11 billion in four "world equity" fund categories - emerging market, global equity (which usually includes the US as well as foreign markets), international equity, and regional equity funds. That brought the total net assets in such funds to $540 billion, calculates the Investment Company Institute in Washington, D.C., which represents the mutual fund industry.

Like their US counterparts, most stock markets around the globe rebounded after losses over the past three years. That rebound made portfolio managers of many funds invested in these markets look smart. Eaton Vance Greater India, for example, returned a whopping 122 percent last year, among the best of all funds investing globally.

On average, the hundreds of funds investing abroad outdid similar domestic offerings. For example: A typical foreign fund investing in large companies made 33 percent for its shareholders last year, compared with 26 percent for a similar fund invested in the US. Funds invested in small foreign companies did even better - close to 60 percent.

And a weakening dollar gave many mutual funds that invest in, say Europe, Canada, and Japan, extra kick.

So far, the streak has continued into 2004. Small-cap international funds, those investing in smaller companies, returned 5.9 percent through March 10. Shares of international funds that include bigger firms, rose 2.9 percent, calculates Lipper.

A risk for new international investors is that the big gains may have already happened. Investors will be fortunate to get a 5 percent annual return over the next five years, says Tim Guinness, manager of Guinness Atkinson Global Innovators Fund, a large-cap growth fund in London.

Nonetheless, some analysts hold that investors should consider putting a portion of their portfolio into mutual funds investing abroad. Maybe 10 percent, says Mr. Roseen.

Here's why:

Diversification: Though many foreign markets tag along with the ups and downs of the American markets - or even vice versa on occasion - there is often enough difference in performance over time from the US market to provide extra stability to an investment portfolio.

"Best not to have all the eggs in the same basket," says Thomas Tibbles of Forward Hansberger International Growth Fund in Toronto.

Don't get too narrowly focused, experts warn. Single-country mutual funds may perform extraordinarily one year. The Russian stock market was up 57 percent last year, for instance. Hong Kong's benchmark index, the Hang Seng, rose about 50 percent last year. The Hang Seng China Enterprises Index, which tracks 32 Chinese- incorporated companies listed in Hong Kong, rose 152 percent. Thailand's benchmark index more than doubled last year.

But "no one is very good at predicting that sort of thing," says William Rocco, an analyst at Morningstar, a Chicago firm that tracks mutual fund performance.

Mr. Tibbles suggests a more guarded approach of investing in a fund with broad international coverage. Still, Mr. Guinness argues every investor should have a 5 to 10 percent exposure to the rapid-growth economies of East Asia, including China. He helps manage two funds invested in this region, the Guinness Atkinson Asia Focus Fund and the China & Hong Kong Fund.

Dollar devaluation: The US is piling up record deficits in its balance of payments of more than $500 billion a year. That, says Tibbles, can foreshadow a weakening of the dollar. International investors are sheltered somewhat from its fall because they own stocks denominated in foreign currencies. So, if the dollar falls, the dollar value of their foreign stocks goes up.

However, the dollar has already fallen sharply against the currencies of its major trading partners - 12.2 percent last year. And it's not clear whether devaluation will continue at the same pace this year. "Perhaps not at this point of time," says Tibbles. But unless the trade deficit shows signs of shrinking, the dollar may well tumble again, he adds.

Value: In many foreign countries, stocks aren't as high-priced in relation to corporate earnings as in the US. That's reassuring for those investing overseas.

The challenge is that not all economies are growing as fast as the US economy. Europe, for one, is lagging. But Japan's economy does show some life after 12 years of near stagnation. Growth in the fourth quarter of 2003 ran at a 6.4 percent annual rate. The bench market Nikkei Stock average saw a 24.5 percent gain last year. Stocks of small Japanese firms did even better. Investors in Fidelity's Japan Small Company Fund enjoyed almost a 60 percent return in the past 12 months, and that's considered average in comparison with its peer funds, according to Lipper.

Before plunging in, investors should be aware of risks involved in foreign investing, analysts say. One is that it involves foreign-exchange risks. The rise in value fueled by the dollar's decline could turn into losses should the greenback rebound.

Another is that the fees and other costs can be higher than for domestic funds. In 2002, for example, a typical shareowner in a regional fund invested in Latin America, Asia, or Japan paid 2 percent or more of her assets in costs, notes Emily Hall, a Morningstar analyst. "But you don't have to pay through the nose," she adds, if you're careful.

A third risk exposed by the mutual fund scandals is that foreign funds, by setting stale prices for shares, allow traders to make arbitrage profits at the expense of long-term investors. "Late traders" take advantage of financial news after the price has been set to buy or sell quickly.

However, notes Ms. Hall, many well-run international funds, such as those managed by Fidelity and T. Rowe Price, set "fair prices" for their shares to discourage such "timing" practices. Moreover, some funds charge redemption fees on the sales of shares that have been held for only a short time.