Much has been written about the importance of portfolio diversification. Investors have likely seen many articles about the benefits of asset allocation in trying to achieve the optional balance between potential returns and protection against downside risk.
Asset allocation generally focuses on the percentage of your portfolio that is allocated to the three major asset classes stocks, bonds and cash. Most advisors and many investors take that to another level in terms of sub-asset classes such as large cap and small cap stocks. For bonds this might include an allocation to short-term and intermediate-term bonds, as well as perhaps corporate and government bonds.
Another key aspect of asset allocation is global diversification. This means diversifying not only among stocks, bonds and cash, but also diversifying among these asset classes on a global basis. Diversification into securities that focus on non-U.S. stocks and bonds can add another level of diversification to your portfolio. Our client portfolios include global diversification to a level appropriate for the client’s risk tolerance, goals and time horizon.
International stocks and bonds
The reason to invest internationally is the opportunity to expand your portfolio’s diversification beyond the U.S. Though U.S. stocks have consistently outperformed international stocks over the past dozen years, this won’t always be the case over time, or in any given year.
Much of the world’s investing and commerce takes place outside of the United States. We live in a global economy and this extends to the world of investing. Many of the largest and most prominent companies in a number of industries are located outside of the U.S.
Some large, prominent companies that are headquartered outside of the U.S. include:
- Nestle S.A. is a Swiss based food and beverage conglomerate that most U.S. consumers are likely familiar with.
- Toyota Motor Corp. is a major international automaker based in Japan. They operate globally including a major presence here in the U.S.
- Royal Dutch Shell is a major global oil company based in the Netherlands.
- AstraZeneca PLC is a major pharmaceutical company based in the United Kingdom.
Many prominent international companies also issue bonds to raise capital just like their U.S. corporate counterparts. Additionally, foreign governments also issue bonds and other debt instruments much like the U.S. Treasury and other governmental entities.
In terms of numbers, the U.S. represents about 40% of the total market capitalization of all global stock markets. This of course will vary a bit each year based on the relative performance of the U.S. markets compared to the rest of the world.
U.S. companies and international exposure
One school of thought is that large U.S. companies are typically globally diversified in terms of having global operations and having non-U.S. revenue streams. It is true that many large U.S. based multinationals do business in a number of countries around the world and derive a portion of their revenues for operations in other countries.
One notable proponent of the approach that international stocks were not needed in a portfolio due to the global diversification of many U.S. firms was Vanguard founder the late John Bogle. He also felt that some of the risk of investing internationally wasn’t worth it.
While there may be some validity to this argument, we believe one key difference is that companies domiciled outside of the U.S. are run by management based in another country. This may in and of itself offer a degree of diversification in terms of the company’s management style and perhaps some business innovations unique to the country or region.
The importance of international stocks and bonds
With some 60% of the world’s stock valuation consisting of companies headquartered outside of the U.S. not having a portion of your equity allocation in international stocks can result in missed opportunities for investors.
Developed market countries typically have established industrial bases, a relatively stable economic system, a developed infrastructure and a relatively high standard of living. In many respects these countries may resemble the U.S. The financial markets and banking systems in these countries are generally also fairly well established and efficient. Major developed market countries include:
- United Kingdom
- South Korea
- The Netherlands
Emerging market countries are still in the development phase as far as their economy and economic system. Their financial markets and banking systems are typically not as well established as developed market countries. There may be some very solid investment opportunities in the emerging markets, but these investments may be subject to greater volatility and risk as well. Examples of emerging market countries include:
- South Africa
Since the stock market bottomed out in early March of 2009, the U.S. stock market has vastly outperformed foreign stock markets in the aggregate over this time period. This has not been the case during each and every year during this time frame, however.
For example, in both 2009 and 2017 emerging markets equities were the top performing asset class among a group of nine asset classes charted by J.P. Morgan Asset Management on an annual basis. In both years, developed market equities also outperformed both large and small cap U.S. equities as well.
If we step back to the “lost decade” from 2000-2009, international stocks outperformed. For example looking at the total return for the decade of Vanguard’s Total International Stock mutual fund and their Total Stock Market fund shows that the international index fund outperformed the U.S. total stock market index fund by almost 29% over the course of the decade.
Non-U.S. companies issue bonds and debt securities for most of the same reasons that U.S. based companies do. They need additional debt financing in general as part of their balance sheet, or perhaps they need the debt financing for expansion or a specific corporate purpose. Foreign governments also issue debt for similar reasons that the Treasury does here in the U.S.
How to add international exposure to your portfolio
One way to add international exposure to your portfolio is to purchase individual securities such as stocks of non-U.S. based companies or bonds of foreign issuers. The availability of these individual securities will vary.
Many stocks issued by foreign companies are traded in the U.S. as American Depository Receipts or ADRs. ADRs are traded on U.S. exchanges just like shares of stock from domestic corporations. Individual foreign bonds can be a bit tougher to purchase. You will need to find a broker who offers them. Even if they are available, the minimum purchase amounts may be quite high.
For many investors, using mutual funds or ETFs that invest in international stocks or bonds is a better way to add international exposure to their portfolio. These funds are professionally managed and are much easier to buy, sell and hold. Most brokerage firms and custodians will allow you to hold these funds inside your accounts with no issues. They can be traded like any other mutual fund or ETF.
Mutual funds and ETFs can be an efficient way for individual investors to own foreign securities. Using a fund can eliminate many of the issues that you might encounter as an individual investor trying to purchase individual foreign securities directly.
International mutual funds and ETFs may be in the form of passive index funds or they may be actively managed. There are funds that focus on stocks and bonds from developed markets as well as emerging market countries. There are broad international funds as well as more style specific funds. There are funds that are country or region specific as well.
Using mutual funds and/or ETFs to invest internationally allows investors greater flexibility in directing their international investments. Most investors do not have the capability or the resources to invest directly into international stocks and bonds for a variety of reasons. Using a managed account can allow them a greater opportunity to fully diversify the international portion of their portfolio versus investing directly in individual foreign securities.
The daily liquidity of ETFs and mutual funds are a plus as well.
Making or losing money with international investments
International investments make or lose money in similar ways to U.S. investments. Stocks will move up or down based upon factors that influence the company such as the trend in revenues and profits. Foreign bond prices will be influenced by the direction of interest rates just like their U.S. counterparts.
Beyond any gains or losses on the investments themselves, there are a number of factors that influence the returns on international investments for U.S. investors.
Beyond the actual performance of the investment in terms of the local currency, fluctuations in the investment’s local currency and the U.S. dollar can impact the returns to U.S. investors as well. A strong U.S. dollar relative to the local currency will dampen net returns on foreign holdings for U.S. investors. On the other hand, when the U.S. dollar is weak relative to foreign currencies this is a plus for U.S. investors.
There are some international mutual funds and ETFs that employ currency hedging strategies to mitigate or eliminate the impact of currency fluctuations on the fund’s returns.
Political and economic events
Political and economic events that occur in foreign countries can have an impact on stocks and bonds issued by corporations and governments in those countries. If a particular country or region is experiencing an economic downturn, this can impact the results of companies in that country or region.
Governmental upheaval, changes in laws and related factors can have a profound impact on the stock and bond markets in a country as well. These types of issues may be more prevalent in emerging markets countries versus in developed foreign markets.
U.S. markets are generally liquid, and your holdings can be readily traded as needed. Liquidity can vary among international markets and can impact the price you receive for a security when it is sold, or the price you pay for a security when purchasing. The degree of liquidity in a country’s markets can also influence how easily a foreign security can be traded if desired.
How much of my portfolio should I invest internationally?
Opinions vary, but a typical rule of thumb often cited is that 40% of your equity allocation should be in non-U.S. stocks, while 30% of your fixed income allocation should be in foreign bonds. Like any rule of thumb in investing, the amount of your equity and fixed income allocations allotted to international investments will vary based on each investor’s unique situation. Factors include your time horizon for the money and your risk tolerance.
We look at each client’s portfolio as an extension of the financial planning work we do for them. This includes their overall asset allocation and the portion of their portfolio that is allocated to international stocks and bonds.
Like most things in the world today, investing has become a global proposition. While U.S. stocks have largely outperformed internal stocks since the market bottomed out in early 2009, this doesn’t mean that this relationship will hold indefinitely.
The majority of the world’s stock valuation is outside of the U.S. While there can be a relatively high correlation of stock performance between domestic and international stocks, there are some unique factors that can influence international markets.
When you add in emerging market investments, there are a lot of growth opportunities in securities issued by companies and governments outside of the U.S. Limiting your investing to only U.S. securities limits opportunities for growth. It also limits your ability to fully diversify your portfolio and manage risk as well.
Please give us a call if you have any questions about global diversification and your portfolio or any aspect of investing, we are here to help.