While many investors have taken advantage of the six-year rally in U.S. stocks, they may have overlooked attractive opportunities overseas. Despite the recent struggles of some international markets, there are powerful reasons to look outside the U.S. for stock investments, such as enhanced diversification, the potential for better risk-adjusted returns, and more.
Nevertheless, many investor portfolios remain underexposed to international stocks, often due to misperceptions about these investments. So here are Fidelity's responses to five common "myths" investors have about investing in international stocks.
Myth 1: International investing is too risky.
Reality: In combination with U.S. stocks, international exposure can actually lower risk in a stock portfolio. Over the past 65 years, a globally balanced hypothetical portfolio of 70% U.S./30% international stocks has produced better risk-adjusted returns (Sharpe ratio)1 and lower volatility (standard deviation) than an all-U.S. portfolio (see chart below, left). The 70/30 relationship has fared worse over the past decade or so (see chart below, right), but we believe it may revert to its historical norms given the cyclicality of U.S. and international stock market performance.
Myth 2: U.S. stocks usually outperform foreign stocks.
Reality: Historically, the performance of international and U.S. stocks is cyclical: One typically outperforms the other for several years before the cycle rotates (see chart below, left). Recent performance has favored U.S. stocks, but given the cyclical pattern of performance, foreign stocks will likely take the lead again, eventually. Timing these rotations is difficult, though, so investors who are underexposed to international could miss significant gains when the market corrects. Note also that in each of the last 12 calendar years, the best-performing single country stock index has been outside the U.S. (see chart below, right), and the top-performing stock in nine out of 10 market sectors during the past decade belonged to international companies.2 This illustrates the value of maintaining international exposure in any market environment.
Myth 3: U.S. multinationals provide adequate international diversification.
Reality: Over the years, many large U.S. companies with operations overseas have experienced periods when their stock prices have been highly correlated to the performance of the S&P 500. High correlations indicate that investment returns are moving in tandem and typically signal lower diversification. The correlations between major U.S.-based multinationals and the S&P 500 have declined in recent years, but this doesn't necessarily make them good replacements for international stocks in a U.S. investor's portfolio.
The chart below compares the average correlations of several U.S. multinationals in different sectors to international counterparts with U.S.-listed shares. The international stocks shown here have offered lower correlations to the S&P 500 over the past three years, which typically signals better diversification benefits. And while U.S. multinationals may provide some exposure to foreign markets, they still offer only a fraction of the currency diversification that can be achieved by investing directly in overseas markets.
Myth 4: Investors should hedge their currency exposure.
Reality: Currency hedging involves holding a stock denominated in a foreign currency and an equal but opposite position in the currency itself. This is intended to prevent currency fluctuations from hurting the stock price. While it sounds good in theory, the effort and expense involved might not be worth it. Timing currency calls is very difficult, even for professional investors. And currency tends to be a relatively small component of returns.
Historically, earnings growth and price-to-earnings ratios have been far bigger drivers of performance. Most important, currency hedging does not pay off over time. Since 1973, currency hedging has detracted from returns in 50% of quarters, and helped in 50% of quarters (see chart below). And during that same period, the unhedged MSCI EAFE Index has actually beaten the local-currency-denominated (hedged) EAFE by 1.09% on an annualized basis.
Myth 5: Index funds have beaten active funds in international.
Reality: An index fund provides exposure to all available companies—good and bad—in a particular investment universe. By contrast, active managers backed by skilled research analysts have the ability to select (or avoid) specific companies they believe will beat (or lag) the index average.
This is especially notable because company selection is the biggest driver of equity returns—twice as important as country or sector selection (see chart, right). The ability to pinpoint specific opportunities may explain why the average actively managed large-cap international fund has beaten its benchmark index by 0.86% annually, even after fees. In comparison, the average large-cap international index fund has trailed its benchmark by 0.32%.3
That's a difference of 1.18% per year in favor of active funds. And when you consider the power of compounding, it's clear that actively managed international funds may offer more growth potential than index funds alone.
International exposure is an essential component of the stock portion of a balanced portfolio, and it's important not to let myths and misconceptions derail a sound asset allocation strategy. Given this, here are several important considerations about the six-year bull run in U.S. stocks:
- It won't last forever;
- Investors may now have too much U.S. equity exposure, which could increase portfolio risk; and
- We may be seeing the early signs of recovery in a number of markets abroad. (For details on the outlook for global markets, read the latest market update.)
For individual investors, now may be an ideal time to reexamine their stock allocations to see if it makes sense to add more international equities to their investment mix.
Investing in companies overseas comes with political, liquidity, and currency risks, all of which can create price inefficiencies within individual stocks, sectors, or countries. Capitalizing on these inefficiencies requires specialized local knowledge, careful research, and efficient trading. Active managers by definition can maneuver a portfolio to take advantage of these inefficiencies, and potentially produce greater excess return compared with their benchmarks and passive strategies.
Standard deviation shows how much variation there is from the average (mean or expected value). A low standard deviation indicates that the data points tend to be very close to the mean, whereas a high standard deviation indicates that the data points are spread out over a large range of values. A higher standard deviation represents greater relative risk.
Sharpe ratio compares portfolio returns above the risk-free rate relative to overall portfolio volatility. A higher Sharpe ratio implies better risk-adjusted returns.
Correlation measures the interdependencies of two random variables that range in value from −1 to +1, indicating perfect negative correlation at −1, absence of correlation at 0, and perfect positive correlation at +1.
Price-to-earnings (P/E) ratio shows the relationship between a stock price and its company's earnings (or profits) per share of stock.
The 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.
MSCI Europe, Australasia, Far East Index (EAFE) is a market-capitalization-weighted index that is designed to measure the investable equity market performance for global investors in developed markets, excluding the U.S. and Canada.
MSCI All Country World Index (ACWI) is a market-capitalization-weighted index that is designed to measure the investable equity market performance for global investors of developed and emerging markets.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917