Unless you've just spent the last 10 years repairing vacuum tubes on Mir, you know that victory has been declared by the efficient marketeers at Vanguard. As of year's end, the fifteen year return of the Vanguard Index Trust 500 ranked 26th of 243 diversified mutual funds listed by Morningstar. Clearly, you're better off letting Lady Luck (the dart throwing chimpanzee in Paul Harvey's spoof of the "Beardstown Ladies" in this month' EF) pick your stocks than the average fund manager.

This is not entirely unexpected. After all, large cap US stocks exist in an informational fishbowl -- if the Efficient Market Hypothesis (EMH) holds anywhere, it should be here.

In fact, things are not so pretty elsewhere for the dart throwers. For example, 84 of 166 small cap funds managed to beat the Russell 2000 over the past 5 years. Similarly, over the same time period 66 of 128 funds beat the EAFE.

Seventy years ago Ben Graham and his colleagues electrified the financial world with the hostile takeover of Northern Pipeline. Graham had determined that NP held an amount of high quality bonds which greatly exceeded its market value. Today, you or I can determine a company's liquid assets with a few phone calls or a database search. If you subscribe to a stock database service such as Morningstar's Stocktools you can find this data with a few keystrokes. However, in Graham's time such data was not readily divulged to the investing public, and Graham's accomplishment lay more in prying the data loose than in the subsequent takeover. Paradoxically, today's transparent financial system makes such a coup impossible today -- our efficient markets instantaneously impound this sort of information into the price of a security. Graham allowed as much in the early 70s, just before his death. At that time he opined that the entire endeavor of security analysis was no longer worth the candle.

It would seem reasonable to expect that foreign markets, which are not nearly as informationally efficient as the US market, would present better opportunities for the astute investor. The Northern Pipelines may have long since disappeared from the US market, but perhaps they can still be found abroad. There is a problem, however, in measuring the performance of foreign money managers. Just what benchmark does one use? For years I've been unhappy with the ranking system used for foreign funds. The EAFE is heavily weighted towards Japanese equity (30%), and just about any foreign fund will look good next to it. Similarly, the past several years have also not been good to foreign small stocks; a well managed foreign small stock fund will likely underperform a less well managed large cap foreign fund. A mediocre fund with a primarily European large cap focus will find itself by default at the top of any general ranking system; an excellent fund with a focus on small companies in non-European markets will likely find itself at the bottom.

Morningstar Products does categorize some foreign funds as European, Pacific Rim, Latin American, or Emerging Markets, but among diversified foreign funds there is a large variation in regional allocation and market capitalization. How to adjust for this? Fortunately, our friends from Chicago provide us with the tools. It goes something like this:

Morningstar provides median market capitalization and regional allocation (Europe, Japan, Pacific Rim, and Latin America) for each fund. For all but Latin America both large and small cap benchmarks are available. (VIEIF-European/DFA Continental-UK, EAFE-PXJ/DFA Pacific Rim, EAFE-Japan/DFA Japan. For the European small cap component, a 2/1 mix of DFA's Continental/UK funds is used. Median market caps of $12B are assumed for the EAFE-Japan and EAFE-PXJ.)

Returns for each component are interpolated for size using the logarithm of the fund's median market cap. For example, assume the 5 year return for the European large cap component is 10%, and for the European small cap component is 0%. If the median market cap of the fund in question is the same as the EAFE-E, then the European bogie for the fund will be 10%. If the logarithm of the median market cap is half way between the small and large cap benchmarks, then the European bogie for the fund is 5%.

From the 4 bogies for each fund a benchmark return can now be computed from the arithmetically weighted regional bogies, which much more accurately reflects the fund makeup. For example, assume that the fund composition/bogie data looks something like this:

Region	Fund Composition	Fund Cap Weighted Regional Bogie
Europe	50%	15%
Japan	15%	-5%
Pacific Rim	10%	-10%
Latin America	25%	10%

Then, the "benchmark" return for the fund will be:

(.5 x .15) + (.15 x -.05) + (.1 x -.1) + (.25 x .1) =

.075 - .0075 - .01 + .025 = 0.825 = 8.25%

It ain't perfect. For starters, Morningstar doesn't provide hedging info, so this critical parameter has to left out of the equation. Second, the regional allocation is measured only once, at the end of the period. Last, and most important, the benchmark by definition measures only security selection skill, and not asset allocation skill.

Still, it is a better mousetrap. So, Goldie, the envelope please:

Fund Name	Relative Performance (%)
59 Wall St European Equity	-4.05
59 Wall St Pac Basin Equity	1.19
Acorn International	3.85
Aetna International Grth Sel	0.20
AIM International Equity A	1.24
Alliance International A	-1.52
Alliance International B	-3.03
Alliance New Europe A	0.72
Alliance New Europe B	-0.11
American AAdvant Intl EqInst	4.02
American Cent-20thCIntlGrInv	0.58
Babson-Stewart Ivory Intl	-0.18
Bailard, Biehl Intl Equity	-5.39
Bartlett Value Intl A	-1.63
Bernstein Intl Value	4.33
BT Investment Intl Equity	4.29
Calvert World Value Intl EqA	-1.95
Capstone New Zealand	-1.14
Capstone Nikko Japan	3.97
Cat: Diversified Emerging Mkts	-3.56
Cat: Diversified Pacific/Asia	0.67
Cat: Europe Stock	-0.29
Cat: Foreign Stock	-1.23
Cat: Japan Stock	1.64
Cat: Latin America Stock	-1.44
Cat: Pacific/Asia ex-Japan Stk	-4.45
Colonial Newport Tiger T	-1.18
Columbia International Stock	-0.07
Compass Intl Equity Instl	-3.14
Compass Intl Equity Inv A	-3.75
Consulting Group Intl Equity	-1.98
CoreFund Intl Growth A	-1.35
CoreFund Intl Growth Y	-1.20
Dean Witter European Grwth B	3.45
Dean Witter Pacific Growth B	3.01
Delaware Intl Equity A	-0.54
Delaware Intl Equity Instl	-0.28
Delaware Pooled Intl Equity	0.47
Dreyfus Premier Intl GrowthA	-3.83
Enterprise Intl Growth A	-1.80
EuroPacific Growth	2.27
Excelsior International	-2.12
Excelsior Latin America	-0.85
Excelsior Pacific/Asia	-1.49
Excelsior Pan-European	-2.16
Fidelity Adv Overseas T	1.30
Fidelity Diversified Intl	5.57
Fidelity Emerging Markets	-8.32
Fidelity Europe	1.03
Fidelity Intl Growth & Inc	1.39
Fidelity Japan	3.92
Fidelity Overseas	0.90
Fidelity Pacific Basin	3.56
Flag Inv International A	0.92
GAM Europe A	-2.92
GAM International A	10.19
GAM Pacific Basin A	-0.34
Glenmede Instl International	2.25
Glenmede International	3.58
Goldman Sachs Intl Eqty A	1.78
Govett International Eqty A	-2.20
GT Global Emerging Mkts A	-6.45
GT Global Europe Growth A	-4.93
GT Global Intl Growth A	-6.29
GT Global New Pacific A	-7.45
GT Latin America Growth A	-4.12
Hancock Pacific Basin Eq A	-2.01
Harbor International	3.84
Hotchkis & Wiley Intl	3.07
IAI International	-1.74
IDS International A	-3.53
Invesco European	-2.29
Invesco International Growth	-4.64
Invesco Pacific Basin	-3.01
Ivy International A	2.79
Japan	2.03
JP Morgan Intl Equity	-2.15
Kemper International A	-1.85
Kent Intl Growth Instl	-1.23
Kent Intl Growth Invmt	-1.63
Keystone International	-2.97
Lazard Intl Equity Instl	-0.42
Lexington Worldwide EmergMkt	-5.71
Loomis Sayles Intl Eqty Inst	-0.81
MainStay Inst EAFE Instl	-5.12
Managers Intl Equity	0.69
Merrill Lynch Consults Intl	-2.24
Merrill Lynch Dev Cap Mkts A	-1.99
Merrill Lynch Dragon B	-5.06
Merrill Lynch Dragon D	-4.25
Merrill Lynch EuroFund A	1.70
Merrill Lynch EuroFund B	0.47
Merrill Lynch Latin Amer B	-2.83
Merrill Lynch Latin Amer D	-1.96
Merrill Lynch Pacific A	6.32
Merrill Lynch Pacific B	5.21
Montgomery Emerging Mkts R	-3.98
Morgan Stanley Inst Intl EqA	7.04
Munder International Eqty A	-6.06
Munder International Eqty K	-6.06
Munder International Eqty Y	-5.82
Nations Intl Equity Prim A	-5.45
Nations Intl Growth Inv A	-4.02
New England Intl Equity A	-5.38
Nomura Pacific Basin	-0.14
Oakmark International	3.49
One Group Intl Eqty Idx Fid	-1.97
Pacific European Growth A	-6.12
Parkstone Intl Disc Instl	-0.57
Phoenix International A	-2.91
PIMCo International A	-4.38
PIMCo International C	-5.17
Pioneer Europe A	3.91
Preferred International	1.06
Principal International A	1.80
Prudential Pacific Growth A	2.10
Prudential Pacific Growth B	1.58
Prudential World Intl Stk Z	0.85
Putnam Asia Pacific Growth A	6.28
Putnam Europe Growth A	1.44
Quantitative Intl Eqty Ord	-3.38
RBB-BEA Instl Intl Equity	-3.33
Rembrandt Intl Equity Comm	-3.13
RSI Retrmnt Intl Equity	-1.85
Schroder International Inv	-1.13
Scudder International	-1.59
Scudder Pacific Opport	-7.34
SEI International Equity A	-5.84
Seligman Henderson Intl A	-2.59
Sit International Growth	-0.84
Smith Barney Intl Equity A	-3.27
Smith Barney Intl Equity C	-4.23
T. Rowe Price European Stock	0.15
T. Rowe Price Intl Discovery	-1.48
T. Rowe Price Intl Stock	-0.24
T. Rowe Price Japan	-0.66
T. Rowe Price New Asia	-4.64
TCW/DW Latin American Grth B	-5.33
Templeton Developing Mkts I	1.61
Templeton Foreign I	0.20
Templeton Foreign Smaller Co	1.59
Templeton Instl Forgn Equity	1.41
Templeton Pacific Growth I	-3.13
UAM TS&W Intl Equity	-3.75
United International Grth A	1.17
USAA International	2.61
Vanguard International Value	-3.97
Vanguard Intl Eqty European	0.26
Vanguard Intl Eqty Pacific	-0.11
Vanguard Intl Growth	2.93
Victory International Grth A	-3.59
Vontobel Intl Equity	-0.71
Warburg Pincus Adv Intl Eqty	0.62
Warburg Pincus Inst Intl Eq	3.28
Warburg Pincus Intl Eq Comm	1.12
William Blair Intl Growth	3.22
WPG International	-3.99
Wright EquiFund-Hong Kong	-5.85
Wright EquiFund-Netherlands	0.97
Wright Intl Blue Chip Equity	-2.29

(Note: "Relative performance" is the 5 year annualized return in excess of the fund's custon benchmark, as calculated above.)

Some of the results are nonsensical, such as for many of the single country funds (e.g., Capstone New Zealand, and all of the Wright Equifunds). Still, I feel that this system provides a fairer appraisal of the highly diversified funds. For example, the Scudder and T. Rowe Price diversified International stock funds are usually at the top of many recommended lists, and for reasons which have never been clear to me, so are the INVESCO Pacific and European Funds. The above table shows all of these to be lackluster. On the other hand, although both Acorn International Fund has been at best in the middle of the pack in the past 5 years, but when their small market cap is taken into account it can be seen that they outperform. By any standards, the Morgan Stanley Institutional International Fund is a star. Unfortunately, it's closed.

Are any of the fund results statistically significant? Possibly, but to find out you would have to calculate the fund's return and benchmark for multiple periods, then determine whether the series of realtive returns was statistically different from zero. That's a heck of a lot of work, and requires a much bigger database than I have. Perhaps Morningstar could be interested in such a project. However, for the small investor the message is clear: Before you swallow a foreign fund's superior performance whole, season it with an analysis of its regional allocation and market cap.

copyright (c) 1998, William J. Bernstein