U.S. stocks generally are faring better than markets in other countries, prompting questions about what role should foreign stocks play in a U.S. investor’s portfolio.
Is it time to bulk up on foreign issues while bargains last? Or should investors rush for the exits?
“Investors’ sentiment toward international stocks has soured over the last several years, as U.S. stocks have consistently outperformed,” says ReKeithen Miller, portfolio manager at Palisades Hudson Financial Group’s Atlanta office. “Someone with a U.S.-centric investment portfolio would have profited from not having exposure to international stocks.”
Performance an issue. Over the past year, for example, the Vanguard Total International Stock Index Fund (ticker: VGTSX), which owns stocks representing the entire world except for the U.S., has lost about 13 percent, while the Vanguard 500 Index Fund (VFINX), composed of big U.S. companies, has lost only about 1 percent. Over the past five years, the international fund as returned just about nothing, while the U.S. fund has returned nearly 11 percent a year.
But many experts feel the underperformance of foreign stocks makes them cheap to buy ahead of a rebound.
“Markets go in cycles and there will come a point when having exposure to international stocks will be beneficial,” Miller says.
A way to diversify. Steven Schoenfeld, founder and chief investment officer of BlueStar Indexes, which runs an exchange-traded fund focused on Israeli stocks (ITEQ), also believes foreign issues belong in U.S. investors’ portfolios regardless of the ups and downs.
“Foreign stocks represent more than half of the world’s investment opportunity set, and many foreign companies are global leaders in their field, and quite present in U.S. investors’ daily lives,” he says.
“American investors simply can’t ignore half the world when allocating their equity portfolio, especially if it means missing out on some great companies based in both developed and emerging markets. This includes companies like Nestle, Toyota Motor Corp. (TM), Samsung Electronics, Unilever (UL), and Teva Pharmaceutical (TEVA).”
Many experts have long recommended U.S. investors have a healthy dose of foreign stocks – anywhere from 10 percent to 40 percent of a portfolio. Adding foreign issues helps diversify your holdings, so that if U.S. stocks are down some foreign ones may be up.
Also, foreign-stock advocates argue several other countries have more room to grow, offering the prospect of outsized returns.
But in many countries, stocks are more volatile than in the U.S., so the risk of loss is greater. Many economies are shaky, and some countries are plagued with instability and corruption. Those risks are just too much for some experts.
“International stocks should play no part in a U.S. investor’s portfolio,” Michael Lee, managing partner of Tiger Wealth Management in Darien, Connecticut, says. “All they do is add volatility and provide lower returns.”
For the typical U.S. investor, he says, an index fund tracking the Standard & Poor’s 500 index provides enough diversification. And because many of these companies have international operations, the S&P 500 has foreign exposure built in. U.S. companies, he adds, face the most stringent reporting and regulatory requirements in the world.
Currency counts. Another issue with foreign stocks: “currency risk” – the prospect of seeing your gains evaporate when converted to dollars.
“The biggest issue most investors overlook when buying international stocks is currency movements,” says David Twibell, president of Custom Portfolio Group in Englewood, Colorado. “As a U.S. investor, it is exceedingly difficult to make money in international stocks when the U.S. dollar is appreciating against foreign currencies.”
It works the other way, too. A falling dollar makes foreign holdings more valuable. But predicting currency swings is no easy matter.
Nor do stock returns necessarily mirror broader trends like economic growth.
“While economic performance is important in the long term, stocks can still thrive even when things look dire,” says Miller, whose firm typically recommends a 35 percent foreign stock allocation. “Take Brazil, for example. With its shrinking GDP and political turmoil, one would think the stock market would be in a shambles. Nevertheless, Brazil’s Bovespa index is one of the best performing stock markets year to date.”
The Bovespa is up nearly 19 percent this year, defying the downward pressure seen in many countries.
Different perspectives. So do scary world conditions give cause to shun foreign issues? Not necessarily.
“Usually, the worst time to steer clear of an asset class is after a sustained period of underperformance,” says Schoenfeld, who recommends a 25 percent foreign stock allocation.
Standard valuation gauges like the price-to-earnings ratio indicate that U.S. stocks are overpriced, making many foreign markets look like bargains, says Matthew Blume, portfolio manager at Pekin Singer Strauss Asset Management in Chicago. “Thus, having a material exposure to foreign stocks may prove to be more important now than ever before for U.S. investors,” he says, adding that “we are finding many more attractive investment opportunities outside of the United States, primarily in other developed markets, but even in some emerging markets as well.”
He’s especially keen on South Korea, for example.
“Valuations in the eurozone and Japan relative to the U.S. equity market are as attractive as they have ever been,” says Jessamyn Norton, chief investment officer of Spinnaker Trust in Portland, Maine.
“Regions like the eurozone and Japan are struggling to grow or generate any inflation. The U.K. is being weighed down by a potential ‘Brexit,'” Norton says. “Growth in the emerging markets has slowed by a large degree. As a result, investor expectations are incredibly low.”
Because of these extra uncertainties, ordinary investors building nest eggs for long-term goals like retirement are wise to take the long view. If you expect a minimum five-year holding period for your U.S. stocks, you might plan to hold your foreign issues even longer.
Not all foreign markets are created equal. The forces driving developed economies of Europe can be quite different from those influencing markets in Latin America or Asia. Among the most volatile markets are those in the emerging economies, from Brazil and Russia to China, India and Turkey.
Vanguard’s Emerging Markets Stock Index Fund (VEIEX), containing stocks of 22 emerging markets, is down nearly 22 percent over the past year.
“Emerging markets represent approximately 9 percent of the total world equity opportunity set,” Schoenfeld says. “But more significantly, emerging market economies represent closer to 40 percent of the total world economy, and much of future potential global growth.”
How to choose foreign stocks. Picking individual stocks is difficult enough in the U.S., and even harder in foreign countries due to different reporting rules and language issues.
Executing trades on foreign exchanges can be daunting, though some foreign issues are traded in the U.S. Most experts say ordinary U.S. investors should rely on mutual funds and exchange-traded funds.
Some experts recommend index-style funds, with allocations mirroring foreign markets’ shares of global stock assets. Some index funds focus on specific regions and countries, and others specialize in developed markets or emerging ones.
Other experts believe that some volatile, under-scrutinized foreign markets harbor enough bargains – and risks – to justify the higher expenses of actively managed funds.
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“Our take is that emerging market stocks take additional expertise to ensure you avoid pitfalls,” Miller says. “That is why we prefer to allocate holdings in emerging markets to active mutual fund managers instead of simply relying on buying an index fund to gain exposure.”