The Case for International Stocks
Summary:
International stocks may not provide downside protection during a crisis but should provide long-term diversification.
The global stock market is approximately 50% US and 50% international.
The currency risk associated with international stocks has benefits to US consumers.
Although international stocks are more expensive and are less tax-efficient, the impact is not significant.
Current valuations suggest international stocks have higher expected returns than US stocks.
Not owning international stocks could mean missing out on future stock market returns.
We believe splitting your stock portfolio between 50% US and 50% international is sensible.
Benefits and Misconceptions of International Diversification
For most of the last decade US stocks have outperformed their international counterparts. This is after both asset classes saw similarly steep declines during the Great Recession of 2007-2009.
If international stocks didn’t provide downside protection during the last financial crisis and then followed with a relatively lackluster recovery, why should investors consider them an important part of a diversified portfolio?
First, let’s dispel the notion that international stocks, or any other risky asset class, should be expected to provide protection during a sharp decline in US stocks. Returns can be decomposed into two parts:
Economic performance—think the actual profits of a company.
Multiple expansion or contraction caused by the change in how much investors are willing to pay for each dollar of profit, which is often driven by investor sentiment.
In a 2011 study published in the Financial Analysts Journal, which examined 22 developed countries from 1950-2018, the authors showed that while long-term returns are dominated by economic performance, short-term returns are dominated by multiple expansion or contraction. They explain that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.” In other words, international diversification might not work well in the short-term but it should in the long-term.
The reason international stocks provide diversification benefits over the long run is that they offer exposure to a wider array of economic and market forces, producing returns that vary from the US market. As you can see in the chart below, the relationship between US and international stock market performance tends to be cyclical but with unpredictable timing. As such, prudent investors would be wise to determine an appropriate long-term allocation to international stocks and then rebalance diligently over time.
Historical Reduction in Portfolio Volatility
How much of an allocation to international stocks is the right amount? Traditionally many investors have started with a default position of wanting to hold 100% US stocks but were willing to add international exposure if they believed it would reduce overall portfolio volatility and make for a smoother ride. As you can see in the chart below, adding international stocks to an otherwise US portfolio would have historically reduced the volatility up to the point of 70% international exposure.
Based on the above chart, the data seems to indicate that the “optimal” international allocation is 30%-40%. However, we need to be careful about extrapolating past data forward because the reality is we don’t know what will be optimal in the future. So rather than tuning our portfolios based on what would have been “perfect” in the past, it's perhaps wiser to develop a sensible theory and then look to historical evidence to see whether it is supported or disputed.
The Current Landscape
When we look to the academic literature on the topic of international exposure, the default starting point is often not 100% US Stocks, but rather the global market-capitalization weights. After all, this is the most agnostic portfolio and reflects the aggregate viewpoint of all market participants. From this perspective, the US makes up approximately 45% of the global stock market as of December 31, 2019. However most global investment benchmarks, such as the FTSE Global All Cap Index or the MSCI All-Country World Index, weigh the US at approximately 55% because they make adjustments to arrive at an allocation that is more investable for practical purposes. The bottom line is that international stocks make up approximately half of the global stock market, and therefore a reasonable default allocation for stock investing is 50% US and 50% international. Further, when we examine this thesis through the lens of history it is close to what would have been the optimal allocation to reduce volatility in the past.
Additional Considerations
There are a number of considerations that should be evaluated to determine whether adjustments to this default 50/50 portfolio should be made, such as investor objectives, costs to invest, tax implications, and current valuations.
Financial Plan Objectives & Currency Risk
For many investors, the purpose of their portfolio is to provide for future spending, typically during a multi-decade retirement. Since most US investors will make these future expenditures in US dollars, some investors may be concerned about the currency risk that comes along with international stocks. Currency risk, or the risk that foreign currencies will fall in value and thus reduce the return US investors receive on international stocks, is not like other risks though. It has no expected return and although it’s volatile, it is also non-perfectly correlated, which means we would actually expect it to further reduce the volatility of the overall portfolio without reducing expected returns. Thought of this way, currency risk is not such a bad thing!
The more important risk to be considered regarding currencies is what would happen to a US consumer if the the US dollar depreciates and forces a lower standard of living. With a falling dollar, import costs rise, which in turn allows domestic companies to increase prices since there is less foreign price competition. This can ultimately lead to rising inflation, which is what happened in the 1970s and early 1980s and could certainly happen again. Today, there are some indications this may be happening in the UK as a result of the Brexit referendum. Having exposure to international stocks helps diversify this risk.
In the opposite scenario, when the dollar rises, as it has for the past decade, international stocks tend to underperform, which they have. Despite international stocks being a drag on the portfolio during these periods, life tends to be otherwise pretty good for the American consumer, which likely means they can tolerate lower investment returns during those times. Conversely, when the tide eventually changes, having a US-only portfolio that underperforms a global portfolio, while at the same time facing increased costs and other economic headwinds may truly be problematic. So currency risk is a two-way street but the risks to US consumers are asymmetrical and we believe it is riskier to ignore international stocks then embrace them.
Additional Costs of International Stocks
Historically it was significantly more expensive to invest internationally than it was in the United States. Since rational investors only care about returns after costs, this made international exposure less attractive. However, in recent years, the cost to access international markets has decreased significantly. For example, Vanguard’s US Total Stock Market ETF (VTI), carries an expense ratio of 0.03% or $30/yr for a $100,000 investment. Comparatively the Vanguard Total International Stock ETF (VXUS) carries an expense ratio of 0.09% or $90/yr for a $100,000 investment. Although it still costs three times as much to invest internationally, the real cost difference in dollars and relative to expected return is immaterial, thus a relatively weak argument for limiting international exposure.
Tax Implications of International Stocks
US investors pay income tax on dividends and capital gains, regardless of whether the company is based in the US or another country. In addition, the government where a foreign company is located may also tax the income through automatic withholding. On first glance, this creates the potential for double-taxation, which sounds draconian. Thankfully, the US tax code allows taxpayers to claim a foreign tax credit which mostly offsets the taxes withheld by foreign governments when these investments are held in taxable accounts.
In addition, international stock funds tend to have a lower percentage of their dividends classified as qualified dividend income (QDI) which benefit from lower capital gains tax rates. For example, in 2019, Vanguard’s US Total Stock Market ETF (VTI) had 94% of its dividend distributions classified as QDI vs. their Total International Stock Stock ETF (VXUS), which had only 65% of its dividend income considered QDI.
When we combine the impact of QDI with foreign tax withholding we get an interesting dynamic. If we hold international stocks in a taxable account, the foreign tax withholding is mostly offset by the foreign tax credit, but it’s still less efficient than a US-based investment since the QDI percentage is lower. Whereas if we hold international stocks in a tax-advantaged account like an IRA, the lower QDI percentage has no impact, but we’re not eligible to claim the foreign tax credit.
So no matter how we slice it, international stock investments are indeed less tax-efficient than their US counterparts, but often the cumulative difference is not significant. In some internal projections we’ve run, the difference is as little as 0.10% per year, although depending on the specific funds and time periods being evaluated, it could differ. While these are important considerations, we do not think the impact is material enough to significantly reduce exposure to international stocks.
Current Valuations
The growth of our investment portfolio is based on future cash flows divided by our purchase price. As such, the price we pay for an investment has a significant impact on our expected returns. All else being equal, the less we pay for an investment the higher our returns will be, but how do we know what’s cheap and what’s expensive, particularly when future cash flows are unknown?
Robert Shiller, an economics professor at Yale and 2013 Nobel Prize winner, developed a model that is widely accepted as one of the best indicators of how cheap or expensive a stock or market is, and consequently what we might reasonably be able to expect for future returns. His model, referred to as the cyclically adjusted price-to-earnings ratio (CAPE), divides the current price by the average of the last ten years worth of inflation-adjusted earnings. The result tells us how many times earnings investors are willing to pay for an investment. The higher the ratio the more expensive an investment is. However, if we flip the ratio around and divide earnings by price, we get an estimate for future expected returns. In fact, studies have shown this to be one of the best predictors of future returns.
As of 12/31/2019, the CAPE for the US stock market was 31.1 whereas the global stock market (which includes the US) was 24.2. This implies an expected real return of approximately 3.2% for US stocks and 4.1% for a global portfolio. While it’s important not to get anchored to these specific figures, both because there are valid reasons to make adjustments to the model and because they are intended to represent the middle of a wide range of possible outcomes, they do indicate that the US stock market is more expensive than the international stock market. As a result, this model suggests a globally diversified portfolio is expected to outperform a US-only portfolio going forward.
It’s important to note however that the higher expected return associated with international stocks isn’t a free lunch since the lower price is an indication that investors, in aggregate, feel the US stock market is less risky. Furthermore, even if the model’s return expectations turn out to be approximately accurate in the long run, they are not helpful in predicting exactly when the tides may change or how quickly. Nonetheless, it may provide some additional encouragement for investors who are persuaded by the arguments for a globally diversified portfolio but have been reluctant to make the shift due to recent US outperformance.
The Real Risk is the Uncertainty of Future Winners
The ability of international stocks to reduce portfolio volatility is a nice benefit of global diversification, but it’s not the primary reason we believe owning international stocks is so important.
Many investors are surprised to learn that most of the stock market’s returns can be attributed to a small number of big winners. A 2018 study showed that “four out of every seven stocks that have appeared in the Center for Research in Security Prices (CRSP) database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills.”
The fact that there are some big winners out there is what gets stock pickers excited. However, finding these stocks is like searching for a needle in a haystack. Most of the time, stock pickers will miss the needle but incur significant costs in the process. Instead of searching for the elusive needle in a haystack, investors are better off simply buying the entire haystack, knowing that the needle is in there somewhere. It’s for this reason that index and other passive funds consistently outperform active rivals.
Yet, being a passive investor but eschewing international stocks is akin to only buying half of the haystack. What if the future winners are concentrated outside the US? The risk of “missing the needle” could be catastrophic to one’s financial future. On the other hand, the potential dampening effect of owning the entire global market, simply results in getting the market return, which is as much as any rational investor can hope for to begin with.
It may be difficult for US investors to imagine the possibility of the US not continuing it’s reign as the leader of the global market. Investors in the United Kingdom at the beginning of the 1900s (when their market represented 25% of the global market) and investors in Japan in the late 1980s (when their market represented 45% of the global market) felt similarly. Today, both countries represent less than 10% of the global stock market. The story of Japan is especially worrisome. Japan’s Nikkei index hit its high of 38,915.87 in 1989. For the last 30 years, the country has been in a long drawn out recession and has never even come close to hitting that price level again. As of 12/31/2019, the Nikkei index is at 23,656.62, still 40% below its historical high. Even if we assume all dividends were reinvested over the last 30 years, the Japanese market has still not climbed back to its high water mark. Retirees in Japan who weren’t sufficiently diversified with stocks from foreign countries are not in good shape.
We are in no way making that case the the US will go the way of Japan, but we do think there are lessons in humility to be learned by examining history. We should never confuse the improbable with the impossible.
Even though the US has been the largest component of the global stock market for most of the last century, it’s weighting has fluctuated over time and was as low as 29% as recently as the 1980s.
Source: Vanguard White Paper (https://www.vanguard.com/pdf/ISGGEB.pdf)
The Bottom Line
When constructing portfolios we tend to be more concerned with risks that could result in permanent losses of purchasing power rather than “shallow” risks, that, while unnerving, are likely only temporary in nature. As such, we think owning the entire global stock market, without significantly underweighting any part is the wisest decision. The fact that international stocks have underperformed US stocks for much of the last decade is likely only a temporary phenomenon and also means investors can buy into international stocks at a relatively lower price today. More importantly, owning a globally diversified portfolio for the long run minimizes the likelihood of truly unfavorable outcomes over an investor’s lifetime.
As we’ve become better students of not only quantitative analysis but also history, we increasingly feel that 50% exposure to any given country’s stock market is plenty and advise our clients to split their stock portfolio 50% US and 50% international. We take additional comfort in the fact that this allocation closely resembles the world market and, at least currently, increases expected return.