Is it time to go international?

With domestic stock valuations high, investing overseas could finally pay off

Apr 29, 2017 @ 12:01 am

By John Waggoner

+ Zoom

The question for advisers now: When will the hurting stop? More importantly, if international investing is worthwhile, what do you need to tell clients?

No less a personality than John Bogle, founder of The Vanguard Group, has expressed skepticism about the value of crossing the border to invest.

"I'm a great believer in the U.S.," he told CNN Money in March. "Since 1993, the S&P 500 has gone up about 800%. The MSCI EAFE index of international stocks has gone up around 280%. I'm in no position to say whether the same thing will happen in the future or not. But I don't mind betting on the U.S."

Comments like that will come as a shock to advisers, who have been pouring their clients' assets into international ETFs for years. In the past 12 months, $49 billion has flowed into international stock ETFs, according to Morningstar. Of the 10 ETFs with the largest asset flows, six have been international stock ETFs.

(More: Vanguard, iShares dominate ETFs in April)

Unfortunately, clients have had little benefit from international exposure — not in the past 12 months, the past 10 years or even the past 40 years. For the record, the MSCI Europe, Australasia and Far East (EAFE) Index has gained an average 7% a year since 1977, versus 8.3% a year for the Standard & Poor's 500 stock index. If that weren't enough to make clients wonder about adding international stocks, consider this:

Volatility. Adding international stocks has increased a portfolio's average volatility the past five years. EAFE has averaged a 2.9% average annual gain the past three years, versus a 10.1% average annual gain for the S&P 500. EAFE's standard deviation the past five years: 13.28, versus 10.18 for the S&P 500. Much of that volatility stems from political risk in Europe, such as the British exit from the European Union and the never-ending series of Greek debt crises.

Currency risk. When the dollar is strong, returns from foreign funds suffer, and the strong dollar has meant lots of suffering for U.S. investors in international stock markets. For example, when measured in euros, the German stock market has jumped an average 9.9% the past five years, according to MSCI. In dollars: 5.5%. Of course, when the dollar is weak, returns from foreign stocks get a boost. So the best returns from international funds come when the dollar falls and foreign markets rise — which happens, but not that often.

Earnings. Finally, there's the matter of whether you benefit from increased opportunity from international ETFs. After all, there's usually a bull market somewhere in the world. But 46% of the earnings in the S&P 500 come from overseas operations of U.S. companies, according to Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. If you're simply looking for profits from abroad, why bother to go there?

$49BAmount flowing into international stock ETFs in past 12 months

"There's something to be said for that," said Mark Mobius, executive chairman of Templeton Emerging Markets Group. "We treat Unilever as an emerging markets stock because 50% of its earnings are from emerging markets."

But the arguments for international investing are strong as well. Ignoring the rest of the world means missing some great opportunities.

"The reality is that 30% of the world's capital is in emerging markets, and 40% of the world's gross domestic product," Mr. Mobius said. "They not only have high growth, but great managers."

Not only does international investing give exposure to great companies, it can be a good diversifier for a stock portfolio.

"Our view is that stocks are stocks, whether they are in the U.S. or Japan or Germany," said Chris Philips, head of Vanguard's Institutional Advisory Services. "They all carry risks and opportunities. But diversification is the only free lunch out there. It makes more sense to have global exposure than to rely on one country's economic regime. The more inclusive a portfolio is, the better the average experience."

But what about those decades of lousy returns? Past returns, as the Securities and Exchange Commission is happy to remind you, are no indicator of future performance, Mr. Philips said.

Adding international ETFs to a stock portfolio has decreased returns and increased volatility for the past five years — something clients are probably not happy about. How do you address their concerns?

"If you look at the past five, 50 or 500 years, something has to be first and last. There's no indication that what has happened will happen," he said.

The ETF universe has also made it easier for advisers to invest overseas at lower costs than most actively managed international funds — and with greater flexibility and precision. A few examples:

Currency hedges. Currency cycles tend to be long: The trade-weighted U.S. dollar has been rallying since 2011 — it fell in value between 2002 and 2008. Advisers who want to avoid currency risk have a wide array of options, such as the iShares Currency Hedged MSCI EAFE (HEFA), which has gained an average 7.2% the past three years, versus 0.4% for its non-hedged cousin, iShares MSCI EAFE (EFA). WisdomTree Europe Hedged Equity ETF (HEDJ) has gained an average 9.9%. And if you can't decide whether or not to hedge, you can try half-hedged funds, such as IQ 50 Percent Hedged FTSE International (HFXI). It doesn't have a three-year record, but has gained 12.5% the past 12 months, versus 8.5% for the average large-company foreign blend fund.

Regional plays. The iShares India Small-cap (SMIN) ETF has beaten all other international ETFs the past three years, averaging a blistering annual 21.9% gain. That's probably too specialized for nearly any client's portfolio. But contrarians could consider ETFs that specialize in Europe, whose stock market has been in the global doghouse.

Dividends and buybacks. Dividends matter abroad as much as they do in the U.S. WisdomTree Japan SmallCap Dividend ETF (DFJ) has gained an average 11.5% a year the past three years, according to Morningstar. iShares MSCI Japan has risen 5.6% the same period. And PowerShares International Buyback Achievers ETF (IPKW) invests in foreign companies that continually repurchase their own stock. It's up 8.8% annually the past three years.

The international ETF sector is as prone to faddish offerings as the domestic ETF sector is. Several BRIC funds — which invest in Brazil, Russia, India and China — are still languishing in investors' portfolios. The BRIC fad was popular when all four countries' markets were soaring. The appearance of hedged international ETFs leads Mr. Philips to suspect that the days of the super dollar could be numbered. The financial industry is good at launching new products when a trend is peaking.

And if your clients are looking for investments that will shield them from the effects of a bear market in U.S. stocks, international ETFs are probably not going to help, whether they're hedged, pay dividends or stick to one region. Stocks are risk assets, Mr. Philips said, and bad bear markets will claw down most risk assets indiscriminately.

"In the last bear market, risky assets declined, whether they were stocks, commodities or real estate," he said. "If you are concerned about the effects of a bear market, you need to have assets in your portfolio that are not risk assets. That's the role of fixed income. If you expect international funds to zig when the U.S. market is zagging, that's a fool's errand."

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