Investors "going global" has been a fashionable hot topic most of the past decade, and, to a degree, rightfully so. The investment returns from practically all sectors of the international market have been relatively strong compared to domestic performance. However, what is most troubling about the current popularity of international markets is that while some investment in foreign securities makes sense, for most investors this strategy has been oversold. Here is a hard look at the realities of the opportunities being touted in foreign markets. (For a related reading, see Does International Investing Really Offer Diversification?)
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There's little doubt that the extraordinary investment inflows into foreign mutual funds represent performance chasing. This phenomenon has driven up stock valuations in foreign markets, which, in many cases, are no longer considered cheap. The point here is not to abandon the foreign sector, but rather to rationally assess your current position and not mistake the hype and advertising surrounding international investing as unbiased advice. The investment business can recognize a good story when it sees one. Given the disparity of the comparative returns in foreign and domestic markets, "going international" can be made to look very enticing.
Is the Grass Really Greener on the Other Side of the Ocean?
The amusing mantra that the U.S. represents less than half of the world's market capitalization is often repeated. By that measure, much more investment opportunity is perceived to lie overseas. As one pundit put it, "… the real risk is keeping too much of your money at home in the U.S." Investors are being encouraged to have anywhere from 25-50% of their investment portfolios in foreign securities and/or mutual funds. Buyer beware. (For more, see Overseas Investing No Protection Against Downturn.)
How Much International Exposure do You Have?
Probably more than you think – take a close look at your domestic mutual funds. Many of these may have a significant percentage of foreign stocks in their portfolios. Add these positions to your direct international investments, the sum of which should be in the range of 10-15% of your total portfolio. As an appropriate guide, data from 2010 indicated institutional investors were limiting their international exposure to 12-15%.
Where a Company Makes Its Money is More Important than Its Location
Many foreign companies are highly involved in the U.S. For example, a high-profile foreign company like the Unilever Group registers about one-third of its sales in the U.S. And, it is a matter of historical record that the S&P 500 companies have global revenues amounting to 48% of their total sales from products and services produced and sold outside the U.S. If you added in direct exports to these sales figures, these domestic companies are generating more than half of their revenues in foreign markets. Investing in a S&P 500 index fund would be a very safe way of getting some indirect foreign market exposure. (For a related reading, see Go International With Foreign Index Funds.)
The Foreign Currency Pendulum
It's important to understand the impact of currency translations on international investments. For example, European companies conduct business in euros and their stocks are traded in that currency. An American-based fund company with an international fund operating in Europe will convert its dividends, interest income and capital gains from euros into U.S. dollars. A strong euro (weak dollar) buys more U.S. dollars, and U.S. investors in such a fund get a boost in their investment returns. For example, in 2010 the broad international market MSCI EAFE index gained +11.69% in local currency, but the dollar's weakness bumped up the gain to +16.36% when reflected in U.S. currency.
Of course, when - not if - exchange rates cycle the other way, investors will take a hit. Foreign currency swings are mostly unpredictable, cyclical, and an inherent element in international finance. Foreign funds can hedge foreign currency risks, but few do. And if they do, it is an additional expense, which means there's no foreign currency effect - positive or negative.
In the context of international investing, think of a weak U.S. dollar as a tailwind for your foreign stock fund returns and a strong U.S. dollar as a headwind. If your principal motivation for putting money in international funds is the so-called "foreign currency play", that's a risky assumption. Going international requires a long-term investing horizon based on a security's or fund's fundamentals rather than the vagaries of foreign currency movements. (To learn more, read How U.S. Firms Benefit When The Dollar Falls.)
Debunking the Decoupling Theory
One of the aspects of international diversification used by the investment industry to promote investing abroad, the decoupling theory, is misleading, if not outright wrong. While this theory had some credence into the early 1990s, the robust and growing forces of globalization in recent years have unraveled the myth.
The decoupling theory holds that the U.S. and the world's other economies do not depend on one another. Supposedly, the latter have become so strong that they are insulated from an economic slowdown in the United States. Therefore, this theory purports that if stocks are down in the U.S., they'll be up, or at least better, in foreign markets, and vice-versa. The worldwide disruptions in economic and financial markets experienced throughout the late 2000s speak for themselves on this issue. Most economists have been skeptical, if not outright opponents, of the decoupling theory for a number of years.
When it comes to international investing, the real issue is not whether or not you should have foreign holdings in your portfolio, but rather how much and what kind of international commitment makes sense. There's no single formula that fits every investor's individual circumstances. A good way to play is limiting international holdings to 10-15% of your total investment portfolio, and sticking mostly to developed country markets, through broad-based market index funds and/or high-quality managed funds. So-called emerging-market funds are for aggressive risk-takers. If the newly-invented frontier-markets look tempting, try an alternative closer to home – Las Vegas. (For more on this topic, check out The Globalization Debate.)