After the tech bubble burst and markets bottomed in October 2002, the U.S. stock market recovered over the next five years with a 120% gain. While that may sound enviable, foreign stocks doubled the U.S. market over the same stretch, generating a 239% return.
Back then, it was almost heresy to suggest that investing overseas was a loser’s game. But today, with U.S. markets having surged well ahead of foreign markets during the ongoing 10-year recovery from the financial crisis, investors seem to have forgotten the vicissitudes of global investing—that market leadership changes, and a smart, diversified investor allocates holdings to stocks both home and abroad to not miss out when the tide turns.
That’s why we’ve always felt it is important to have some foreign stock market exposure in client portfolios. We have good reason to think there are great opportunities for investors willing to venture beyond our shores today.
A Bountiful Hunting Ground
The U.S. doesn’t have a monopoly on good businesses, entrepreneurial spirit and profit potential. In fact, there are many more companies located outside of the U.S. than within. Consider that Vanguard’s Total Stock Market Index fund, which includes stocks of all shapes and sizes in the U.S., has approximately 3,600 companies in its portfolio. Meanwhile, Vanguard’s broadest foreign stock index fund, Total International Stock, holds shares in more than 7,000 companies. As you can see in the chart below, U.S. stocks only account for roughly half of the global market.
More stocks to choose among doesn’t necessarily mean better results, but it does offer stock pickers a tremendous opportunity. Fund managers are constantly pursuing new investment ideas, and the more options they have to evaluate, the greater the chance that they can find a stock that other investors have irrationally sold at dirt-cheap prices or simply ignored. In other words, international stock markets offer a bountiful hunting ground to our fund managers, who are hungry for new ideas.
Investors have several options when investing outside our borders.“Global” funds, as the name implies, have a worldwide mandate and invest in both U.S. and foreign companies. “International” funds invest in companies based in countries outside of the U.S. Chances are, you use the goods or services of one or more of these non-U.S. companies: Honda (Japan), Nestle (Switzerland), Bayer (Germany), Nokia (Finland) and Samsung (South Korea)— all are names that you won’t find as components of a “U.S.only” portfolio or index.
The countries that make up the international markets are divided into one of two categories, either “developed” or “emerging.” Developed countries tend to have stable political systems, mature economies, high levels of income, established rules of law and transparent regulations governing their financial systems and investment markets. Examples of established foreign markets are Germany, the United Kingdom, Japan and Australia.
Emerging countries typically are in earlier stages of economic and/or political development. As a result, their markets tend to be less stable, more volatile and more susceptible to missteps. They also tend to be faster-growing. Examples of emerging economies include China, much of Southeast Asia, Eastern Europe and Latin America.
Further dividing the foreign-market pie, even younger and more fragile markets, such as those in Vietnam, Ukraine and much of Africa, are known as “frontier” markets; members of this group are in even earlier stages of economic, political and market development. Frontier markets represent a very small slice of the global landscape.
Now that you’ve had our crash course on foreign markets, why should you consider investing in them?
A Passport for Your Portfolio
“Don’t put all of your eggs in one basket.” We’ve all heard the saying before, and it applies to investing as much as it does to life. In investing parlance, it’s called “diversification.” Owning assets that don’t all react to the same consumer, business or economic trends makes your portfolio more resilient: If one investment performs poorly, you have others that may pick up the slack. We believe that diversification is an essential form of risk control in any portfolio.
Diversification comes in different flavors. You can diversify the type of assets you hold—stocks, bonds, cash, real estate, commodities, etc. You can also diversify by owning multiple stocks. And in this report, we are talking about diversifying by investing in stocks of companies based in multiple countries.
If all your investments are in just one country, and that country’s economy or market goes through a major decline, well, your portfolio will likely suffer the full consequences. If you’d put all your eggs in Japan’s basket in the late 1980s, you’d be able to make fewer omelets today than when you started out nearly three decades ago. By the same token, an investment in U.S. markets in the early part of the 21st century significantly underperformed investments in non-U.S. markets for years.
Now, to be clear, we are not saying that the U.S. market is about to crash or is poised for a decades-long malaise. Actually, we remain constructively bullish on America and the strengths of its companies and marketplace. But investing exclusively in the U.S. stock market means your portfolio is wed primarily to the fortunes of just one country. If the U.S. stumbles, for whatever reason, so will your portfolio.
Given the fact that U.S. markets have been global leaders for several years now, it pays to take a broad, longer-term view. Our “efficient horizon” chart to the right measures the risks and returns of portfolios with varying allocations to U.S. and non-U.S. stocks. It clearly shows that adding an allocation to foreign companies in a stock-only portfolio has helped to reduce risk over the last 30-plus years without giving up much in the way of returns.
While a 100% U.S. stock portfolio achieved the greatest average annual return over the period, that excess return came with extra volatility. The “sweet spot” for the best risk-return dynamic in a portfolio is at the point where the curved line begins to go back on itself. In this case, an allocation of 20% to 30% to foreign shares diversifies a hypothetical portfolio of stocks, taking some risk off the table compared to a U.S.-only approach.
We think it makes sense to diversify your stock holdings globally, and we also think that if you haven’t done so already, now might be a good time to consider building your foreign stock allocation.
Countries across the globe have widely different economic and political policies. Some countries are ruled by dictators, others by elected officials. Some countries have pulled themselves out of recession by cutting government spending, while others have increased expenditures. As a result, various nations are in different stages of the boom-and-bust cycle that all economies move through—each country is dancing to a different tune.
At the end of June 2019, the U.S. has benefited from a 10-plus-year bull market in stocks, during which the S&P 500 has returned 440%. During that same period, Europe’s, Japan’s and emerging markets’ recoveries have been much more sluggish. The MSCI EAFE index, a broad measure of developed foreign stocks, is up only 199% and the MSCI Emerging Markets index has returned 189% in comparison.
The chart above shows the difference in calendar-year returns between the U.S. stock market and developed and emerging foreign markets. When the column is above the 0% line, U.S. stocks outperformed, when it is below, foreign stocks outperformed. In particular, you can see in the recent cycle that U.S. stocks have outperformed in five of the last six years. But the chart also shows extended periods when the trend went in foreign stocks’ favor, like the aforementioned run of outperformance following the dotcom bubble bursting in 2002.
Given the recent drastic outperformance in the U.S. stock market and economy, it is fair to say that our recovery is much further along than that of Europe or Japan. As a result, foreign markets are potentially earlier in their bull market run (not to mention cheaper), suggesting there may be more upside opportunity in stocks outside of the U.S.
Stocks on Sale
One way to compare values in the U.S. and foreign stock markets is to look at the average price-to-earnings (p/e) ratio of stocks in those markets. The p/e ratio tells us how much investors are paying for one dollar of profit. Right now, stocks are on sale in foreign markets compared to the U.S. stock market. For every dollar of earnings earned by an U.S.-listed company, investors pay $24. In developed foreign markets, shareholders are currently paying less than $16 for that same dollar of earnings, and in the emerging markets, just $15.
While American companies have typically justified higher prices for their stocks because the U.S. economy was likely to grow at a faster clip than foreign economies, the gap between the U.S. and developed and emerging markets stocks’ valuations has widened to a point, and economic growth outside the U.S. has picked up to a pace that foreign stocks appear to be selling at enough of a discount to be highly attractive.
Boots on the Ground Matter
We believe that foreign markets are ripe for outperformance by savvy, boots-on-the-ground stock pickers.
While stories regularly appear in the media reporting that the average actively managed fund underperforms its benchmark as well as comparable index funds, we think there’s another piece to this story.
Facts are facts, and it’s true that the average fund manager will have a difficult time consistently and meaningfully outperforming a cheaper index fund. But at Adviser Investments it’s our business to avoid the average and look for the superlative. We aren’t looking to invest with run-of-the-mill fund managers. Our process seeks to find and invest with active managers whose bull, bear and indifferent track records have withstood the test of the markets, often with less risk than their relevant benchmarks.
In a 2017 report, Fidelity Investments compared the returns of large-cap actively managed and indexed foreign stock funds against their benchmarks over every rolling 12-month period from 1993 through 2016. They found that, on average (after fees), actively managed international funds generated 0.84% a year in excess returns over their benchmarks (so if the benchmark’s average return was 1.00%, for example, the average active fund returned 1.84%), while the average international index fund under performed by 0.31% a year. In other words, active managers outperformed—significantly.
This fact doesn’t mean that we’re willing to go with “average” when it comes to overseas investments. We don’t take any less care selecting foreign fund managers to invest with than we do for our U.S. managers. It simply reinforces our belief that it is possible to identify quality active managers who can outperform over the long-term.
Diversifying your portfolio among high-quality, experienced active managers running individual portfolios in bonds, U.S. stocks, foreign stocks and other assets is the best way, in our opinion, to build and compound wealth over the long haul. And we promise to go to the ends of the earth to find those managers!
This material is distributed for informational purposes only; and is not financial or investment advice. Speak to your financial adviser before taking specific action. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.
Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
Past performance is not an indication of future returns. We do not provide legal or tax advice, nor sell insurance products. Tax, legal and insurance information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice, or as advice on whether to buy or surrender any insurance products. Always consult an attorney or tax professional, or licensed insurance professional regarding your specific legal or tax situation, or insurance needs.
© 2019 Adviser Investments, LLC. All Rights Reserved.