If you want to experience the taste of authentic Italian food, don't go to the Olive Garden -- go to Italy.
Likewise, if you want the authentic diversification benefits of international exposure, look for foreign small-cap stocks -- not large multinationals based abroad.
The breadsticks are innocent
As global markets converge and become more correlated, investors looking for a free lunch need to dig a bit deeper these days for stocks that will add diversity to their portfolios.
Simply owning a market-weighted foreign fund -- such as the iShares MSCI EAFE Index, which has top holdings in multinational heavyweights such as Honda (NYSE: HMC ) and AstraZeneca (NYSE: AZN ) -- isn't enough because these companies are well-ingrained in the U.S. economy. Nor is it enough to own U.S.-based blue chips with global operations such as Monsanto (NYSE: MON ) and Kraft (NYSE: KFT ) .
Go to the source
If you seek pure international exposure, you need companies that deal primarily in local markets and have little or no exposure to the U.S. economy. In other words: foreign small caps.
Before I scare you off, consider that a 1995 study by Dimensional Fund Advisors co-founder Rex Sinquefield found that "international value and international small stocks diversify U.S. portfolios more than EAFE." That's because isolated foreign small caps typically trade independently from U.S. markets, and by doing so, they "reduce the standard deviation of a domestic portfolio" while simultaneously increasing expected returns.
The problem many U.S. investors have with choosing foreign small caps is that so few are listed on major U.S. exchanges. According to Capital IQ, only about 400 foreign businesses capitalized below $2.5 billion (out of many more thousand) trade on the NYSE or Nasdaq, including MF Global (NYSE: MF ) and MercadoLibre (Nasdaq: MELI ) . That may be because there are substantial costs associated with trading in the United States, including Sarbanes-Oxley and exchange regulations.
But that doesn't mean you should give up. One option is to invest in a mutual fund that invests specifically in foreign small caps, such as Vanguard International Explorer (currently closed) or First Eagle Overseas. Unfortunately, many of these funds charge a pretty penny for their services. According to Morningstar, the average expense ratio on a foreign small- and mid-cap value fund is a pretty pricey 1.57% -- a number that gives rise to significant incurred and opportunity costs.
Given those figures, it's worth your while to research some individual foreign small-cap stocks on your own. If you'd like some ideas for getting started, the Motley Fool Global Gains service can help. Among the 30-some stocks it recommends are small caps from Argentina to Macau. On average, the picks outperform the S&P 500 by 10 percentage points.
To see what foreign stocks the team recommends now, a free 30-day trial gives full access to all of their picks. To get started, just click here.
This article was first published March 4, 2008. It has been updated.
Todd Wenning is the man who will fight for your honor. Todd does not own shares of any company mentioned. MF Global is a Global Gains recommendation, and Kraft is an Income Investor selection. The Fool's disclosure policy is the hero you've been dreaming of.