In 2007, mutual funds specializing in non-U.S. stocks returned a fat 16%, while funds with diversified holdings in U.S. equities returned just over 6%. In fact, the foreign-stock funds have beaten domestic-stock funds over periods of two, three, five, 10 and 15 years, according to Lipper, the fund-tracking company.

On top of that, owning foreign stocks helps a U.S. investor diversify risk by reducing a portfolio’s volatility, thus improving compounding over the long term.

Why is it, then, that so many surveys show that the typical U.S. investor does little more than dabble in foreign stocks? The average small-investor portfolio has 10% to 12% of its equity investments committed to foreign stocks, while many experts recommend 20% to 40%. “People tend to invest more in their local stocks,” says Wharton finance professor Karen K. Lewis, adding, “There are big gains from diversification that people don’t exploit.”

For insight into this, Lewis set aside questions about foreign stocks’ returns, which vary widely, and focused on whether foreign stocks continue to dampen portfolio volatility as much as experts have thought. Perhaps investors have discovered they do not.

Lewis’ findings are described in her December 2007 paper titled, “Is the International Diversification Potential Diminishing for Foreign Equity inside the U.S.?” She finds that foreign stocks’ volatility-dampening effects have indeed diminished, but that they are still strong enough to make foreign-stock investing worthwhile. “The bottom line is that there still are benefits to international diversification in 2007 and 2008,” she said.

But it takes some digging to prove it. “The first question has to do with: ‘Have things changed?'” she said.

Advocates of foreign stocks have long argued that stocks in different countries march to different drummers. Thus, when U.S. stocks are down, stocks in Europe, Asia or Latin America may be up, and vice versa, making foreign holdings attractive.

The Globalization of Securities Markets

But in previous decades, foreign markets may have been more independent of the U.S. market than they are today. In the past, it could be hard for investors in one country to trade stocks of another. One might need an account with a foreign brokerage, or with a domestic one having overseas operations. Even if this problem could be overcome, it was often difficult to research foreign stocks or to know what the data meant. Many countries, for example, do not follow the accounting and reporting standards U.S. investors are accustomed to. “People have argued that it’s hard to diversify because it’s harder to get information about foreign companies,” Lewis said

Globalization of the securities markets has changed this. Today, U.S. investors can choose among some 3,000 mutual funds and exchange-traded funds that hold foreign stocks. They can leave the research to the pros by investing in managed funds, or they can match the performance of markets in specific countries or regions by purchasing index-style funds and ETFs. And while changing exchange rates can affect returns, investors don’t have to worry about converting dollars to yen or euros; they can do all their foreign-stock investing in greenbacks.

Bottom line: convenience is no longer an obstacle to foreign-stock ownership.

But some experts theorize that this ease-of-investment has reduced the benefits of foreign stocks because it has caused stocks around the world to march in unison. This could diminish the volatility dampening long thought to be a benefit of foreign investing. “This is fairly accepted conventional wisdom — that the U.S. and foreign markets have higher co-movement,” Lewis said. Certainly that is evident in the worldwide stock slump at the start of this year. An international investor worried that the subprime mortgage mess will depress U.S. stocks may, for example, cut back on any investment deemed risky — in the U.S. and overseas.

In addition, many companies now are diversified internationally. Thus, Coca Cola, though a U.S. company, will reflect the ups and downs of conditions overseas. These interdependencies can create a “contagion effect,” Lewis says. “You have multi-nationals in all these markets. It’s not the case that we are islands in ourselves. We really are more integrated.”

Does that really mean international diversification no longer pays? “Let’s look at how the benefits of international diversification for a U.S. portfolio holder might be declining over time,” Lewis says, pointing to her research. She compared the ups and downs of U.S. stocks, represented by the Standard & Poor’s 500, with the movements of baskets of foreign stocks. Stocks that tend to move in step with one another have a high “covariance,” while those moving in different directions have a low one.

“I found that the covariances among … stock markets have indeed shifted over time for a majority of the countries,” she states in her paper. “However, in contrast to the common perception that markets have become more integrated over time, the covariance between foreign markets and the U.S. market has increased only slightly from the beginning to the end of the last 20 years.” In addition, she found that the foreign markets’ volatility, or “standard deviation,” “has declined over this time.”

Throwing ADRs into the Mix

Foreign stocks at first appear less appealing in recent years because they are more likely to parallel the movements of U.S. stocks. But this diminishing benefit is more than offset by the fact that foreign stocks have become less risky, as is shown by their reduced volatility.

Thirty years ago, a U.S. investor could have reduced annual portfolio volatility by 30% by mixing in foreign stocks. Though the figure has fallen, it remains at a healthy 15%, Lewis found.

As a practical matter, not many U.S. investors would have held all the foreign stocks they would have needed to get the full benefit 30 years ago, since that would have required them to put 75% of their stock holdings into foreign issues. Today, an investor can get the full benefit by putting just 20% into foreign stocks, Lewis found.

To explore why U.S. investors still fall short of this allocation, Lewis looked at whether they may be getting the same benefit by investing in American Depositary Receipts, which are foreign-stock stand-ins traded in U.S. exchanges but not counted as foreign-stock holdings. Many U.S. investors are attracted to ADRs because these securities may meet accounting and reporting standards that are more stringent than those in many other countries.

Lewis found that ADRs tend to keep pace with U.S. stocks, so they provide less diversification benefit than do foreign stocks traded on foreign exchanges. She concluded that “the diversification properties of [ADRs] are inferior to investing in foreign markets directly.” This also meant that adding a mix of ADRs and foreign stocks to a portfolio would not work as well as adding just foreign stocks.

Lewis emphasizes that her study did not look at whether foreign stocks offer better returns than U.S. stocks. Many investors who do like foreign stocks believe there are more bargains in markets that have undergone less scrutiny, and many think foreign economies, especially the emerging ones, have more room to grow than the U.S. economy does, offering the potential for greater stock-market gains. But even without these considerations, owning foreign stocks is still a good idea for U.S. investors, she says, because it helps reduce risk.

Is the International Diversification Potential Diminishing for Foreign Equity Inside the US?