Advisors Are Moving Back Into U.S. Funds

There was a profit motive at play, too. The typical international fund returned 16% last year vs. 6.4% for their domestic counterparts. In fact, that has been the story for much of the last decade. The difference was even more pronounced for emerging-market offerings. They posted average returns that exceeded 36.4% in 2007. All that wasn't lost on many investors: According to Lipper, a net $63.3 billion flowed into international funds last year while $38.4 billion headed for the exits of U.S.-focused offerings.

But Rustman, like many advisors, is starting to reconsider that decision. He's not completely abandoning international mutual funds. However, after months of reading miserable headlines about the stock market, Rustman and others think the U.S. may have finally bottomed out. Now, they say, is a perfect time to start trimming international or using cash to add to U.S. exposure on the cheap in anticipation of the inevitable rebound. Studies have shown that asset allocation — a term used to describe the industries or sectors your portfolio is exposed to — is one of the main influences on returns. So any time the experts start changing course we like to see if there is any wind in their sails.

"We are taking money off the table on the international side," says Rustman, who has cut exposure there in half. "I think Europe is going to catch our cold."

It's not hard to figure out why advisors like Rustman were down on the U.S. Since last summer, when the subprime crisis really started to unravel, investors have been whacked with round after round of bad news. The country's biggest financial-services companies have written down the value of billions of dollars of assets. Some have gone out of business, declared bankruptcy or desperately resorted to cash infusions from outside investors. A continuous stream of economic data points to the fact that the economy may well be in a recession, leading to historic actions by the Federal Reserve. Meanwhile, company after company has reported dismal earnings. That doesn't leave much to cheer about. Indeed, over the last year the S&P 500 has lost 7%. That means a majority of investors, regardless of their sophistication, are seeing their account balances shrink at the same time they are paying higher prices at the pump and at the supermarket checkout line.

But 2008 may be the year when that trend starts to reverse itself. A recent study by Bespoke Investment Group, a firm founded by two former analysts at Birinyi Associates, the well-regarded research outfit, looked at how far 22 major indexes had fallen from their 52-week highs. Surprisingly, the S&P 500 has held up better than 14 of them, including benchmarks in Japan, India, Italy, France, Australia, Germany and Spain. China was the worst of the bunch having dropped 46% off its 52-week high. (Of course, some of these markets had further to fall than the U.S.) Bespoke also found that head-to-head against Europe, the U.S. looks like the better deal. The S&P 500 is expected to post earnings growth of 10.8% this year vs. a slight loss of 0.1% for a comparable index in Europe. The money flowing overseas seems to have leveled off. According to Lipper, in February, the most recent month available, both U.S. and international funds saw net inflows around $3 billion.

Even bad news doesn't seem to be impacting the market like it did just a few months back. Since early March, when many experts think stocks hit a bottom, the Dow has gained 7%, despite companies like General Electric (GE), Washington Mutual (WM), Merrill Lynch (MER) and Wachovia (WB) announcing poor performance. The market could take a hit when Citigroup (C) reports earnings Friday. However, it seems like many investors have already accepted the fact those two companies will announce write-downs. In essence, they have come to expect it. The big question is whether we have seen the last of it. Several chief executives seem to think so. The heads of both Goldman Sachs (GS) and J.P. Morgan (JPM) have said recently that they believe the worst is behind Wall Street.

If, indeed, the U.S. is showing signs of getting back on track, there are rumblings that what inflicted the U.S. market will work its way through markets in Europe and Asia next. In other words, just as the U.S. is seeing light at the end of the tunnel, the rest of the globe may be in store for some dark days. And that's what has many advisors pulling up stakes and heading back to the safe shores of home.

In that case, the argument boils down to one of asset allocation. All things being equal, a typical, well-diversified, moderate portfolio will have 60% of its assets in equities. Maybe 20% or so of that will be in international and emerging-market funds. Recently, smart advisors re-worked those percentages, increasing their international holdings, scaling back on the U.S. and pumping some money into cash as a defensive position. Now, though, they are once again in the process of manipulating those levels. Rustman has cut back his international and emerging-market holdings to 5% of his portfolios. A good rule of thumb for the next year: Keep international to around 10% to 15% of your portfolio, less if you can't stomach the ups and downs.

Much of the money advisors are starting to put in U.S. funds will come from cash positions that built up while they tried to weather the market turmoil. Some of it will also come from new contributions or from trimming international positions that have run their course. So what is that money buying?

Shashin Shah, founder of SGS Wealth Management in Dallas, is currently ratcheting up his clients' U.S. exposure by 2% to 10%. He is looking at large-cap funds from American, Vanguard and Dodge & Cox. Shah argues the stock market is usually a leading economic indicator by six months. So he sees a broad U.S. turnaround beginning later this year or early in 2009. "I think we are closer to the bottom than maybe people think," he says. "The economy will probably rebound by this time next year." Large caps, he thinks, are the smart play in that situation. "Large caps will lead us out," he says.

Vincent Barbera, director of financial planning at TGS Financial Services in Radnor, Pa., is on the same page. "So many things were overvalued," says Barbera. The last year, obviously, has changed all that. "There is an opportunity to make a significant purchase in the domestic market." Barbera, a value investor, likes Third Avenue Value (TAVFX). This fund thrives on investing in companies that have been beaten down so that they trade at a 20% discount to a price target. The fund is in the top 10% of its Morningstar peer group over the trailing decade. He is also partial to funds at First Eagle. "[First Eagle] doesn't take any unnecessary risks," he says.

Rustman likes the midcap space. Large companies, he thinks, could suffer because they sell their goods in international markets. He makes an exception for what he calls disruptive companies like eBay (EBAY) and Amazon.com (AMZN) that could benefit because of their locks on given sectors. He's also making smaller, more aggressive bets on the rebound here in the U.S. by investing in the Rydex Strengthening Dollar 2X fund (RYSDX). If the dollar gains ground on foreign currencies this fund doubles that percentage increase.

"At this point I am buying future earnings," says Rustman. "There are definitely some headwinds for the global economy."