For years, investment experts have advocated that investors put at least a piece of their portfolio into international stocks. The reasoning was that international investing offered an unbeatable combination of better returns and a decrease in portfolio price swings.
But in recent years international investing has offered not only lagging returns but an increased tendency to behave like the U.S. stock market. That reversal of fortune has international advocates on the defensive and supposedly internationally diversified investors questioning why they invested overseas in the first place.
Blake and Meg Chapin of Plainfield invest in international stocks and funds, but they have pulled back from plans to put additional money into overseas markets. At one time, the plan was to put a healthy chunk of their investments into international stocks, Blake says. But as the tech bubble burst, so did the returns on the Chapin’s international holdings. “We’ve taken a beating, but we’re holding on to them,” he says.
The dreary performance of international stocks may tempt you to run for the exits, though. In the five years ended Feb. 28, international mutual funds–funds that invest outside the U.S.–returned a paltry 0.96 percent annually, according to Lipper. During the same period, diversified U.S. stock funds returned an annualized 7.44 percent. Global funds, those that can invest both in and out of the U.S., also lagged behind U.S. funds. Global funds returned an annualized 4.49 percent in the five years through February.
Returns don’t tell the whole story, though. International stocks used to tend to zig when the U.S. market zagged, creating lower overall price volatility for international investors. But that diversification benefit appears to be going away.
During the last five years, the average international equity manager was 80 percent correlated to the U.S. stock market, says David Herro, portfolio manager at Harris Associates who oversees the Oakmark International Fund and Oakmark International Small Cap Fund. That means four-fifths of the time, international equity funds behaved much like a U.S. stock index fund.
The correlation problem is caused, in part, by overly cautious investment managers. “The problem is most managers invest their portfolios so that they’ll look like an index,” Herro says. “They’re scared to look differently.”
If more international managers ignored the stock indexes, and instead focused on finding good values from among the thousands of stocks traded globally, their performance would improve, he says.
So, should you avoid international stocks? Probably not, but depending on your situation you may be better off keeping all of your investments in domestic stocks. You’ll have to take a look at your investment goals, your tolerance for short-term losses, and the investment choices available to you.
Herro notes that eliminating international from your portfolio would be cutting yourself off from a huge chunk of the world’s investments. The more choices available, the more likely a portfolio manager will be able to find stocks that produce good returns. “The number one reason to go overseas is to enhance portfolio return,” Herro says.
Don’t be put off by the lagging returns, because now may be when international stocks begin to outperform. Just as international stocks looked like a no-brainer at the end of the 1980s only to lag, now it’s the U.S. market that is perceived as the place to be, says Chip Wendler, vice president at T. Rowe Price International Inc. in Baltimore.
“The perception back then was that international was golden,” Wendler says. Investors were abandoning U.S. stocks because Japan “was going to take over the world.”
At the time, that view seemed reasonable. During the 10 years ended December 1989, a popular international index, Morgan Stanley Capital International EAFE, produced an average annual return of 22.8 percent, compared with the U.S. market return of 17.6 percent, according to data provided by T. Rowe Price.
But over the next 10 years, international equities produced average annualized returns of just 7.3 percent, compared with a U.S. market return of 18.2 percent.
But just when things look terrible for international stocks may be the exact time to get in, Wendler says. While you can’t assume that international stocks will come back only because they’ve lagged for so long, there are some fundamental reasons why international may be primed for a rebound.
U.S. stocks higher priced
Looking at earnings, U.S. stocks are much higher priced than their European counterparts, Wendler says. While U.S. stocks were trading recently at about 40 times their earnings, European stocks were at about 20 times earnings. Business confidence is improving in Italy, Germany and France, T. Rowe Price officials believe.
Moreover, Europe continues to place a stronger emphasis on equity investing, which should draw in capital and support stock prices, Herro argues. While this phenomenon quietly has been taking place for years, there are signs that investors in places like Germany are dropping their bond focus for the stronger returns of equity ownership. “This is a major positive,” Herro says.
And managers at T. Rowe Price expect the woes in Japan to at least abate, if they don’t go away altogether. “Japan may not recover, but it will stop imploding,” Wendler says.
Another major positive for international stocks is the possibility that the U.S. dollar will end its major climb. Whenever the dollar gets stronger, investment in other currencies falls in value, all else being equal. During a recent five-year stretch, U.S stocks returned 57 percent more than non-U.S. stocks. Take out the strong U.S. currency and the difference would have been 33 percent, Wendler says. Predicting currency changes accurately is next to impossible. But should the U.S dollar hold at current levels or weaken after its tremendous run higher, the effect on international holdings would benefit.
Avoid high fees
No matter how well international stocks do, there are situations where you should stay away. If an international fund charges too high a fee, you’ll be better off in a U.S. stock index fund. An international fund that charges 2 percent in fees negates any chance for outperformance when compared to a U.S. stock index fund charging 0.5 performance in annual management fees, says Christopher Jones, vice president at Financial Engines, a Palo Alto, Calif., online advice firm. “This is lost on people,” he says.
Picking an international fund is similar to choosing a domestic one. You can invest in an index fund offered by a firm like Vanguard (www.vanguard.com) and T. Rowe Price (www.troweprice.com), or go the active route.
For active funds, Morningstar’s Web site (www.morningstar.com) created a screener that is a good place to start. The screen sifts through funds to identify those with a lower-than-average expense ratio, a $3,000 or less minimum, better-than-average risk and an overall ranking by the firm of four or five out of five. Click on the expense ratio heading to sort them by cost, which should give you a list of the lowest-cost funds.
Timothy Schlindwein, managing principal for Chicago-based Schlindwein Associates, said his firm is placing more emphasis on medium and small companies with their international investment allocations, because there seems to be more potential to add value.
And Schlindwein avoids emerging markets funds altogether. Emerging markets can produce eye-popping returns and losses. Many international funds include emerging markets in their mandate, and that’s probably the best route to getting emerging markets exposure.
Two or more funds is better
Not sure how much to put into international versus U.S. funds? Global fund managers can make that decision for you. You’re probably better off picking two or more global funds to lower the chance that a single manager’s mistakes won’t severely damage your portfolio.
No matter which route you choose, a dollop of international stocks now could give your portfolio a boost ahead of a global recovery, assuming you’re not paying too much in mutual fund expenses.
