Foreign stocks are soaring and Americans are pouring money into them. But although overseas equities have captured investors’ fancy before, there’s a twist this time: More investors are embracing passive, index-style investing, ignoring the long-held belief that active managers can beat indexers by uncovering bargains in inefficient foreign markets.

Have conditions really changed enough to make indexing pay off as well in foreign markets as it has in the U.S.? It may be too soon to know for sure. But international equity markets and American investor behavior are clearly evolving. “Whatever the argument was in the past for active versus passive, it’s different today,” says Richard J. Herring, professor of finance and international banking at Wharton. “It’s different today because the indices [that guide indexed investments] are better constructed.”

Experts note that foreign stock index funds have begun to beat many actively managed competitors in recent years. And it is natural for Americans impressed with indexing stateside to try the strategy overseas. “People chase performance. That’s what’s happening,” says Richard Marston, professor of finance and economics at Wharton.

From the start of the year through mid-April, the leading foreign stock index, the Morgan Stanley EAFE, was up more than 9% versus 4.2% for the chief U.S. index, the Standard & Poor’s 500. The EAFE rose more than 13% in 2005, the S&P 500 about 4.8%.

Some markets are on fire. In the 12 months ended April 13, mutual funds specializing in Latin American stocks returned a stunning 82.5%, according to Lipper, the fund-tracking company. Japanese stock funds returned nearly 46% and Chinese stock funds were up 34.4%.

In February, the most recent month for which figures are available, investors poured nearly $19 billion into foreign-stock mutual funds, compared to $8.4 billion for U.S. stock funds.

With stellar returns, it’s obvious why Americans are drawn to foreign-stock funds. But American investors have also grown enamored of indexers, which now hold about 15% of assets invested in foreign-stock funds, up from about 5% in 2001, according to AMG Data Services. “People want diversification at the cheapest cost,” notes Wharton finance professor Jeremy Siegel, who talks about the latest economic developments in a podcast included in this issue. “As an extension to the indexed domestic portfolio, many advisors are now recommending an indexed approach to the foreign portfolio. It probably will continue.”

Siegel says the typical American investor should have 40% of his or her equity portfolio in foreign stocks, since many foreign markets have greater potential for growth than the well-developed U.S. market. “The U.S. will, over time, become a narrower and narrower slice of the world market. Just as you don’t want to confine yourself to two industries in your portfolio, you don’t want to confine yourself to one country…. I really advise broad diversification.”

Stripping Out Japanese Shares

Rather than hunt for hot stocks, as actively managed funds do, indexers simply buy and hold the stocks in a market indicator such as the S&P 500, or EAFE, which stands for Europe, Australia and Far East.

In recent years, Americans have embraced indexing for U.S. stocks, and now have about $347 billion tied up in the 174 S&P 500 funds, according to fund tracker Morningstar. Other mutual funds, plus a slew of exchange-traded funds (ETFs), track a variety of U.S. indexes, from the Dow Jones Industrial Average to the Nasdaq 100. ETFs are mutual funds that trade like stocks through brokerages.

U.S. indexers are hot because numerous studies have shown they tend to beat actively managed funds over time, largely because indexers incur lower costs and trigger smaller tax bills. Costs are low because indexers do not need teams of stock pickers. And because the turnover in their holdings is modest, their annual realized profits don’t generate the big year-end capital gains distributions that shareholders get from many managed funds, making indexers friendlier at tax time. Low costs and taxes spur compounding over long periods.

But investors have long been less enthusiastic about indexing foreign stocks. Many experts argued that because many foreign stock markets are small and not thoroughly examined by analysts and money managers, smart stock pickers could uncover enough gems to consistently out-perform foreign-stock indexes. In the 1980s and 1990s, performance data tended to support this view.

There’s debate about whether conditions have changed. Foreign-stock indexers have beaten managed funds over the past three years, but only slightly, with annualized gains of 33% versus just under 32% for managed funds, according to Morningstar.

Among emerging-market funds, indexers led by about 3 percentage points a year during that period. That’s drawn a lot of attention, since many had thought the smaller, emerging markets had the greatest pricing inefficiencies that favored active managers.

Foreign-stock indexing produced unenviable results in the 1990s because Japanese stocks were a major component of the EAFE index. Since Japanese stocks were in a deep slump following a bubble, active managers could beat the index by steering clear of those issues.

But in 2002, Morgan Stanley changed the index, stripping out the large number of Japanese shares not available to international investors. That reduced Japan’s influence and made the index a more accurate mirror of foreign markets. In addition, Japan’s economy started to recover and its stocks began to rebound.

As a result, the EAFE index has become harder to beat. “I think that competition is getting pretty steep,” says Siegel, who advocates index-fund investing for foreign stocks.

When Active Management Makes Sense

American investors also benefited as the dollar weakened against the euro from 2002 through 2004, according to Marston. As the dollar fell, a holding in euros gained value in dollar terms.

Although the dollar grew somewhat stronger against the euro in 2005, the resulting damage to Americans’ European-stock holdings was more than offset by stock gains in those countries, Marston notes, adding that many foreign stocks went up as those countries began to recover from the 2001 recession, which they did later than the U.S.

American investors typically have about 13% of their stock and bond portfolios in foreign stocks, Marston says. He recommends a portfolio that’s 75% stocks and 25% bonds, with at least 20% of the total in foreign stocks. “If I thought investors would invest more [in foreign stocks], I would recommend more. I just believe it makes sense from several different perspectives.”

Some industries, such as automobile manufacturing, are healthier in Japan and Germany than in the U.S., he notes. The nuclear-power industry is strong in France but not in the U.S. “You just don’t want to confine your portfolio to the industries where we happen to be good.” Also, Marston believes the dollar will fall over time from factors like the U.S. current account deficit, making foreign holdings more valuable in dollar terms. “As a foreign-equity investor, I’m going to benefit from that.”

But although Marston believes indexing is a good strategy for U.S. stocks, he thinks active management remains a better bet for foreign ones. Many foreign countries are politically and socially unstable. And many are slow to address economic problems, he suggests. Japan, for instance, dragged its feet with banking reform that was obviously needed. “You want an active manager who is willing to pull the trigger and get out of a country.” Indexers stick with their country weightings no matter what. Also, there are still enough inefficiencies in foreign markets for managers to more than make up for the costs of hunting down bargains, Marston adds.

Herring has doubts about that. It is very expensive to do research on companies in foreign countries, especially in the smaller, less-developed ones, he notes. Trading costs are much higher in many foreign markets than in the U.S., putting a further drag on portfolios run by active managers, who buy and sell much more often than indexers.

He also says that many of the smaller foreign markets suffer from liquidity problems, with small numbers of shares in circulation and limited numbers of traders. That means a sizable trade, such as one by a mutual fund manager, can upset the balance of supply and demand. A stock’s price can therefore jump as a manager is accumulating it, and fall while he sells, reducing trading profits.

Finally, says Herring, Americans’ enthusiasm for foreign stocks has led securities firms to disperse analysts all over the world. As a result, it becomes harder and harder for active managers to pry out undiscovered gems.

Marston, Siegel and Herring all note that foreign stock markets and international investing opportunities have changed so much in the past few years that it is hard to draw firm conclusions from the data about indexing versus active management.

All agree, however, that American investors should hold a significant stake in foreign stocks. Marston, unlike his colleagues, believes active managers can still earn their keep. But whatever edge they have over indexers probably will shrink over time, he adds. “I think that, gradually, the pricing of the larger blue-chip-type companies will become more efficient.”