There’s an iconic New Yorker cover illustration that shows skyscrapers on Manhattan’s West Side dwarfing a smaller, mostly empty space between the Hudson River and the Pacific Ocean. Tiny land masses in the distance are labeled China, Japan and Russia, while Europe is missing entirely from this sardonic map, dubbed “View of the World from 9th Avenue.”
Truth is, it’s not just New Yorkers who have a myopic view of the world. As we come off an incredible year for capital markets, many U.S. investors—and their portfolios—display a distorted perspective, with U.S.-based investments dwarfing (or crowding out entirely) foreign holdings. As of mid-2019, only 37% of households investing in mutual funds owned any international or global stock funds at all, an Investment Company Institute survey found. But U.S. investors need to consider that non-U.S. asset classes might provide greater opportunity and could help drive portfolio return in the years ahead. Here are five reasons to put more foreign mutual funds and ETFs in your portfolio.
One of the biggest challenges in portfolio construction is overcoming human biases. People overweight the importance of what’s happened recently (recency bias) and cling to the familiar (home country bias). This is true regardless of where they live. “Aussies tend to have up to half of their portfolios allocated to their home country stocks. Investors from Latvia and Peru undoubtedly exhibit the same tendencies,” says Bryan Lloyd, a CFA and international equity portfolio manager at Harding Loevner.
Recognize home country bias is human, and fight it with data. “The U.S. is roughly 55% of the world’s equity market cap. It is not too much of a leap to argue that the allocation should start there; 45% international, and 55% U.S.,” says Lloyd. “Tactically add some more weight to the U.S. because many of the client’s future liabilities will be in U.S. dollars.”
Of the more than 44,000 previously self-directed investors who signed up for Vanguard’s advice service between 2014 and 2018, 65% had no international allocation—meaning the median international holding was 0%. After Vanguard’s computer-driven models reallocated their portfolios, their median international allocation was 35%.
A common misperception among U.S. investors these days is that international markets typically lag the U.S. market. Indeed, international equities have lagged U.S. stocks in six of the last seven calendar years. That’s why overcoming recency bias and studying longer-term performance is essential.
When Morningstar analyzed rolling 10-year data going back to 1970, it discovered that when U.S. returns are less than 6%, international equities outperform 94% of the time. Furthermore, when U.S. returns are less than 4%, international equities outperform 100% of the time. In other words, international equities win when U.S. stock performance is weak—one of the objectives of diversification.
Moreover, after a year when the S&P 500 returned 31.5%, international markets might be more reasonably valued—meaning they present the opportunity to buy quality on the cheap. “International and emerging market equities offer attractive relative valuations versus the 19 times price to earnings multiple that comes with investing in the S&P 500 at this time,” says Chris Dillon, a T. Rowe Price multi-asset investment specialist.
Investors sometimes rationalize avoiding foreign equities this way: A large percentage of U.S. mega-cap stocks are multinationals, so why do I need to invest overseas? “It’s certainly a common objection, and while it’s partially true, we don’t believe in artificially constraining our pool of high-quality companies,” says Brian Kersmanc, deputy portfolio manager for GQG’s international equity strategy.
Just because a company is in the S&P 500, does not always mean it is in the top market position, an important nuance in terms of future growth. “Take spirits for example,” says Kersmanc. “The number one and number two companies in the world by market cap are based in China and the UK, respectively. From our perspective, looking at companies globally makes us better investors both domestically and internationally.”
Even if you find it hard to shake home country bias, current valuations make a powerful case for international diversification. Lloyd points out that investors with a strong U.S.-orientation can buy multinationals based in Europe that do business in the U.S. at “a 20% to 30% discount” to what they’d pay for U.S.-based multinationals with the same earnings growth and profitability.
Investors also need to consider macro factors in their investment strategy. From Brexit to Donald Trump, the global order is changing. The world is moving away from the post-World War II geo-political landscape. Portfolios should change accordingly.
“Going forward, we expect the world to be different, and material exposure to international equity markets is warranted,” says Dillon. “We see a multi-polar world developing, where certain regional alliances are forming and will operate without the U.S.”
Without a diversified exposure to international holdings, you can end up with a gap in your portfolio allocation. That’s why investing in this asset class through actively managed funds—which analyze the fundamentals of each company in their portfolio—as opposed to purely index funds, can make sense for the long term.
Finally, U.S. investors should remember that volatility applies here too. While U.S. markets continue to climb, there is potential election risk. “While a low probability outcome, in an election year for the U.S., the chance for political change exists, which could alter tax policy,’’ says Dillon. “International equities are arguably insulated to such a risk.”
Then there’s the U.S. dollar. It’s been strong of late, but a falling dollar would provide additional tailwind for foreign stocks. “With a multi-polar world emerging in conjunction with growth differentials between the U.S. and the rest of the world closing, an argument can be made for a sideways to atrophying U.S. dollar from here,” says Lloyd. “Investors forget that 2017 was a year of U.S. dollar weakness and during that year, while the S&P 500 was up over 21%, international stocks in general returned in the range of 30%, while emerging market equities retuned over 40%.”
Home bias isn’t new. But now is the time for U.S. investors to see the changing dynamics of the world and adopt a global portfolio view. “U.S. investors tend to think of international investing the way we used to think about that awful-tasting cough medicine our parents gave us when we were sick,” muses Lloyd. “We hated it, but knew that it was somehow good for us.”
CREDIT: kate_sept2004/GettyImages; joe daniel price/GettyImages