International investing: How to set an allocation you — and your clients — can live with

Life is full of complicated, eminently debatable questions. Could the Red Sox beat the Dodgers this year? What will happen next year when Vanguard has all the money in the world? And what is the correct allocation between international and U.S. stocks?

Despite their recent runup, adding international stocks to a portfolio has been like adding water to your gas tank. The Standard & Poor’s 500 stock index has gained an average 7.7% a year over the past decade, while developed international stocks gained just 1.5%.

Nevertheless, most experts agree that adding international stocks increases your opportunities: U.S. stocks account for just about 54% of the world’s stocks, measured by market capitalization. Europe and Asia account for 22% and 20%, respectively.

Sam Stovall, chief investment strategist of U.S. equities at CFRA Research, says that their baseline allocation for international stocks is 25%, which he says has produced the best risk-adjusted return since 1969, when the MSCI indexes were first created. In portfolio composed of 60% stocks and 40% bonds, that translates to 45% U.S. stocks and 15% international. “The question is, ‘What do you think of that allocation now?’” Mr. Stovall said.

This year, most clients would probably say, ‘Not much.”

After all, the average U.S. large-company blend fund has gained 10.3% year to date, while its foreign cousin has gained 17%. If you think that’s good, the typical emerging markets fund is up more than 23% this year, according to Morningstar.

“I’ve heard of investors of various stripes aligning their allocation to global market capitalization – that is, approximately 50% U.S. stocks and 50% foreign,” said Joe Davis, global chief economist at The Vanguard Group. “That’s not what we do, but we’d say there’s clearly a diversification advantage from having a substantial portion of your stock portfolio overseas. Forty percent is often our starting point.”

A 40% allocation is a big departure from a few decades ago, when a 20% allocation to foreign stocks was considered daring.

Mr. Davis sees three reasons for that, starting with the reduced cost of investing overseas. International funds have always been somewhat more expensive than U.S. stock funds, but those costs have fallen dramatically in the past decade. The second is that U.S. investors have become more worldly. “There’s an increased realization that there are economic opportunities outside the U.S. borders,” Mr. Davis said.

And, finally, there’s the matter of performance chasing. “There’s more interest in international investing during periods of U.S. underperformance,” Mr. Davis said.

Indeed, a flood of new money into international funds may be contributing to their recent good performance. Investors have poured $356 billion into foreign stock funds and ETFs since January 2015, according to the Investment Company Institute, while yanking a net $192 billion from U.S. stock funds.

Mark Bass, a financial planner with Pennington Bass & Associates, has typically recommended a 50-50% split between international and domestic stocks. “We’ve been that way for a long time, and we’re probably out of the mainstream with some of our financial services colleagues,” Mr. Bass said. “And of the foreign part, we’ve been 30% to 35% in developed markets and 15-20% in emerging markets. It’s a lot easier to make that case when U.S. stocks are overpriced.”

A big part of keeping clients at that allocation is managing expectations, Mr. Bass said. “Developed and developing markets phase in and out every five to seven years,” he said. “You have to tell clients up front that that’s what’s going to happen.”

As an adviser, you have several ways to choose how, exactly, to manage international diversification. If your main concern is cost and ease of management, your best route is most likely a world index fund, such as Vanguard Total World Stock Index (VTWSX) as a core position. The fund mirrors the FTSE Global All Cap Index, a float-adjusted, market-capitalization-weighted index designed to measure the market performance of large-, mid-, and small-capitalization stocks of companies located around the world. The fund has gained 10.63% a year the past five years, vs. 10.33% for the average world stock fund, according to Morningstar. Expense ratio: Just 0.21%. The fund has an ETF version (VT), priced at 0.11% annually.

You could also choose a fund that adjusts its allocation according to management outlook – with the caveat that these funds, as with all active funds, have a spotty record at best. The current champion is Morgan Stanley Global Opportunity (MGGIX), up an average 21.35% a year the past five years and 35.89% so far this year. The fund is 74% in developed markets and 26% in emerging markets. Expense ratio: 0.81%.

Another method is to set an allocation and adjust it opportunistically. “A 50% allocation to foreign stocks is really a lot,” says Steve Janachoski, CEO of Brouwer & Janachowski. “We’re generally around 25% to 33% foreign stocks. “Is that the right range? It’s hard to argue that U.S. large companies aren’t the best managed, and that they don’t have as much political and currency risk,” Mr. Janachoski said. “It’s best to tweak at the margins, rather than make full-sized bets. Emerging markets have been pummeled, they’re cheap – maybe tweak that.”

However you pitch your foreign asset allocation, don’t make the mistake of telling clients that international stocks will ease the pain of a bear market. When the U.S. sneezes, the rest of the world still gets pneumonia, Mr. Stovall notes. During the 2007 bear market, the S&P 500 tumbled 51%, including reinvested dividends. MSCI EAFE tumbled 57%, and emerging markets plunged 61%. Life is complicated.