The real story
- In any given year, the best performing stock market is usually outside the US.
- International diversification has historically improved risk-adjusted returns.
- US-based multinationals may not provide adequate international exposure.
- Hedging currency risk doesn't always benefit investors.
- Actively managed funds may offer potential outperformance in international markets.
The long-term rally in U.S. stocks has benefited many investors. However, it's also led some investors to have more of their portfolio devoted to U.S. stocks than they may have intended. Overexposure to a single geography breeds diversification risk in a portfolio, leaving it vulnerable to a downturn in that geography and underexposed to a rally in other parts of the world. With that in mind, investors may want to re-examine the global mix of their stock allocations, and consider increasing their international exposure if they’re too heavily weighted in domestic stocks. In fact, Fidelity customer data suggests that millions of investors may be under-exposed to international stocks.1
There are powerful reasons to invest outside the U.S., such as enhanced diversification, the potential for better risk-adjusted portfolio returns, and a larger opportunity set, among others. Nevertheless, many investors still lack international exposure, often due to misperceptions about the asset class. Here are five of the most common myths investors cite for not investing overseas, contrasted by what Fidelity believes are more realistic perspectives about the asset class.
Myth 1: The US is the world’s best-performing stock market
Reality: Not true. While U.S. stocks have had higher returns than overseas equities in aggregate for the past several years, the best-performing stock market for each of the past 30 years has been located outside the United States (The graphic above shows the best-performing developed stock market during the past dozen years). Historically, developed market international and U.S. stock performance is cyclical: One typically outperforms the other for several years until the cycle reverses (see chart). Timing these rotations is difficult, though, which is why it’s important to have both U.S. and non-U.S. exposure in an equity portfolio. Investors underexposed to foreign stocks could miss significant gains when overseas markets rally, or suffer losses when U.S. stocks decline.
Myth 2: International investing is too risky
Reality: International stocks in combination with U.S. stocks can actually lower risk in an equity portfolio, compared with an all-U.S. portfolio. That's because historically, the performance of U.S. and international stocks has not typically been perfectly correlated,2 which thereby reduces risk. Historically, a globally balanced hypothetical portfolio of 70% U.S./30% international equities has produced better risk-adjusted returns (Sharpe ratio) and lower volatility (standard deviation) than an all-U.S. portfolio (see table, below). Also, the absolute return of the globally balanced portfolio is almost level with that of the all-U.S. portfolio, despite the recent multiyear rally in U.S. stocks. And given the cyclicality of U.S. and foreign stock returns, history suggests their relationship could revert to its historical norms at some stage.
|International equity exposure may decrease portfolio risk over the long term|
|1950 to 2016||U.S. Portfolio||International Portfolio||Globally Balanced Portfolio 70% U.S./30% Int'l|
|Hypothetical “globally balanced portfolio” is rebalanced annually in 70% U.S. and 30% foreign stocks. U.S. equities: S&P 500® Total Return Index; International equities: MSCI ACWI ex-USA Index. Source: Bloomberg Finance L.P., Fidelity Investments (AART), as of Feb. 16, 2017. Past performance is no guarantee of future results. It is not possible to invest directly in an index. All indexes are unmanaged. Please see appendix for important index information.|
Myth 3: US multinationals provide adequate international diversification
Reality: The stocks of large U.S. companies with operations overseas (multinationals) are sometimes highly correlated to the performance of the overall domestic stock market. Highly correlated stocks in a portfolio may indicate a lack of diversification. Therefore, U.S. multinationals are not always good replacements for international stocks for diversification purposes. The table below compares the average correlations of several U.S. multinationals to their foreign counterparts with U.S.-listed shares. The non-U.S. stocks shown have had lower correlations to the S&P 500 over the past three years, which typically signals better diversification benefits.
|International stocks can provide more diversification benefits than U.S. multinationals|
|Three-year mega-cap correlations with the S&P 500, 2014 to 2016|
|Procter & Gamble (U.S.)||0.45|
|Hyundai Motor (So. Korea)||0.31|
|Source: Morningstar, as of Dec. 31, 2016. Company names shown here are for illustrative purposes only, are not representative of all companies, and are not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results.|
Myth 4: One needs to hedge currency to improve international stock returns
Reality: Actually, history shows that hedging currency returns doesn't improve international stock returns—at least not over the long term. Currency hedging (holding a stock denominated in a foreign currency and an equal but opposite short position in the currency itself) is intended to prevent currency fluctuations from hurting the stock price. While it sounds good in theory, the time and cost it takes to hedge currency has not paid off over time. Since 1973, currency hedging has detracted from returns in 50% of quarters, and contributed to returns in 50% of all quarters (see chart).
Timing currency movements is extremely difficult, even for professional investors. Plus, currency tends to be a relatively small component of returns over time, especially compared to earnings growth and price-to-earnings ratio expansion. What’s more, on an aggregate basis, an unhedged strategy (MSCI EAFE U.S. Dollar Index) has outperformed a hedged strategy (MSCI EAFE Local Currency Index) by roughly 1% on an annualized basis since 1973.3
Myth 5: After fees, actively managed international funds don’t compete with passive strategies
Reality: Just the opposite is true. Historically, actively managed international funds have significantly outperformed their passive peers, even after fees. In fact, since 1993, the average actively managed large-cap international fund has beaten its benchmark index by 0.84% annually (see chart).4 In comparison, the average large-cap international index fund has trailed its benchmark by 0.31%. While averages can conceal significant variation between individual time periods and funds, that’s a difference of 1.15% per year (including fee impact) in favor of active funds.
When it comes to equity performance, company selection is by far the biggest driver of returns—twice as important as country or sector selection. This gives larger active managers the advantage, because they have the resources and flexibility to select or avoid specific companies in an index, while many index funds are exposed to all companies—good and bad—in a particular investment universe.
For each of the past 30 years, the best-performing stock markets have been located outside the United States. That means investors who were focused solely on U.S. stocks missed out on attractive opportunities for growth and diversification. Historically, a globally balanced portfolio consisting of 70% U.S. and 30% international equities has provided competitive absolute returns, lower volatility, and better risk-adjusted returns than an equity portfolio consisting of just U.S. stocks.
Fidelity believes taking an active approach to security selection can be a compelling way to achieve favorable returns when investing internationally. So consider increasing your allocation to international stocks. It could make a world of difference in your portfolio.
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Sharpe ratio compares portfolio returns above the risk-free rate relative to overall portfolio volatility. A higher Sharpe ratio implies better risk-adjusted returns. Standard deviation is a statistical measure of market volatility, measuring how widely prices are dispersed from the average price. A low standard deviation indicates that the data points tend to be very close to the average, and a high standard deviation indicates the data points are spread over a larger range of values. A higher standard deviation represents greater relative risk.
Standard & Poor’s 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. S&P 500 is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates.
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