2011 has not been a great year for international equity mutual funds, especially compared to domestic U.S. fund counterparts. But this situation could very well change and investors in the near future, according to analysts at Standard & Poor's Equity Research.

First the numbers.

After having two great years, in the first half of 2011 through the end of June, the average gain for international equity funds was a paltry 1.7%. This compared to an average gain of 3.4% for funds invested exclusively in U.S. domestic stocks.

But Alec Young, an S&P international equity strategist, and colleague Todd Rosenbluth, an S&P mutual fund analyst, said that a slowing U.S. economy going forward could make it hard for domestic-invested funds to continue outperforming international funds -- especially if the dollar continues its slide against the Euro and other currencies (it’s down 7% so far this year).

As Young explains, international funds that invest in companies that denominate their overseas returns in local currencies see their returns rise when those overseas earnings in foreign currencies get converted to dollars.

Even so, he said that for international stocks and international mutual funds to really take off in the second half would require a convergence of a number of factors, not all of which are looking particularly likely.

These factors, he said, would include an easing of sovereign debt “stress,” greater momentum in international manufacturing, commodity price stabilization, and a more robust U.S. recovery. 

With both the U.S. and global economies looking weaker, Young told On Wall Street that there were “still two things that could happen that would help international equities funds:  a QE3 program by the Federal Reserve, or an expansion of the European Economic Stability Fund.” 

The Fed at the end of June ended its latest quantitative easing program, called QE2, of buying Treasuries and, at that time, Fed Chairman Ben Bernanke said he did not anticipate having the Fed engage in a third such program.

But some economists and Fed watchers think that the dramatic change in the outlook of the U.S. economy evident in recent days may make him rethink that view.  Also, there are many experts in Europe who think that the economic stability fund established to prop up the economies of Greece, Portugal and other weaker Euro Zone states is too small and may need to augmented. 

Looking at the universe of international funds available to investors, S&P’s analysts are recommending three which they say are both top performers and which are invested in companies with strong credit profiles and/or a history of earnings and dividend stability. They include:

-- Lazard International Equity Portfolio fund (LZIOX), a relatively small fund with only $38 million in assets that has returned 5.8% so far in 2011 with below average volatility.

-- Templeton Foreign Fund (TEMFX), up 5.3% this year, and a fund with relatively low turnover.

-- MFS Research International Fund (MRSAX), up 5.1% this year, and a fund that has outperformed its peers for the past five calendar years.



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