Since the Great Recession, American equity markets have substantially outperformed their foreign counterparts. Investors have come to regard foreign equity exposure as ballast that depresses overall portfolio returns. At the same time, Americans are constantly informed of the soaring price movements of domestic equity indices such as the Dow Jones Industrial Average and the S&P 500. It’s easy to overlook the significant market capitalization that lies overseas. This article will offer a rationale for foreign diversification and some ideas for implementing the idea.
The Why of International Investing
Investors naturally tend to weigh their newer experiences more heavily than the more distant past. It’s a behavioral finance phenomenon known as "recency bias." It can lead to suboptimal investment outcomes. Foreign stocks have been around a long time. While coherent foreign stock indices have not been around as long as the S&P 500, most researchers are comfortable with data going back at least as far as 1970.
This longer historical record of foreign investing is more positive. As the chart below illustrates, the annualized volatility of a globally diversified portfolio is minimized with a weighting of approximately 30% to 35% foreign stocks. Relative to a U.S. only portfolio, volatility falls from 15.2% to about 14.5% while return only falls from 10.6% to 10.4%. That’s a fine tradeoff in terms of risk and return. (For related reading, see: Does International Investing Really Offer Diversification?)
Apart from the raw numbers, common sense tells us that expanding our opportunity set to foreign markets can smooth returns. Economic cycles can differ substantially across borders. Our own Federal Reserve has been raising interest rates for 18 months. On the other hand, the European Central Bank continues to buy $60 billion in bonds monthly in its quantitative easing program. Japan’s central bank has also been highly accommodative.
Industry weightings are different. The S&P 500 has more medical services and high tech while foreign stock indices have more financials and commodities. Investors who stay at home will miss out on many world-class companies. Industry leaders such as Samsung, Unilever, Nestle and Nissan trade on overseas exchanges. It’s reasonable to assume that the fortunes of each region’s companies will wax and wane at different times.
There is also a valuation argument that favors foreign investment. S&P 500 stocks are trading at much higher prices relative to historical earnings than their foreign counterparts. Research Affiliates has been tracking the cyclically-adjusted price/earnings (CAPE) multiple of dozens of economies. Both developed and emerging foreign markets are trading at CAPE multiples around 15, below their historical median. The S&P 500 is trading at a CAPE multiple of 29, nearly twice its historical median.
Granted, the CAPE multiple is merely suggestive of future stock market performance. However, a reasonable person could conclude there is more room for earnings multiple expansion with foreign stocks. (For related reading, see: Getting Into International Investing.)
The How of International Investing
Today the U.S. stock market comprises 53% of the world’s aggregate market capitalization. I’m not arguing against a continued preponderant weighting in U.S. stocks. In fact, a continued home bias seems to make sense empirically. However, a weight of one-fourth to one-third foreign stocks could be helpful. There are good tools available to provide this foreign equity exposure.
Foreign investing has become much easier since the turn of the century. The growth of exchange-traded funds (ETFs) gives the retail investor low-cost entry into diversified market baskets of foreign securities. The structure of ETFs is tax efficient and they trade on virtually any brokerage platform—like stocks.
The following table lists several ETF options with expense ratios of under 0.15%. Such inexpensive investment options would have been unimaginable 20 years ago. The table is color-coded. The first three entries offer broad exposure to the entire spectrum of foreign markets. In fact, you can pick any one of these options as a one-stop solution.
The next three entries are concentrated in the developed markets of Europe and Japan and the final three focus on emerging markets. The key takeaway here is that a focus on longer term results argues for some allocation to foreign stock markets. And the process can be pretty straight forward.
(For more from this author, see: How Your Health Savings Account Can Be a Tax Shelter.)