Rebalancing? Foreign Stocks May Not Be as Cheap as They Seem

At one of Morningstar's investment conferences years ago, a top executive at one of the big mutual fund shops said that he maintains a simple contrarian portfolio alongside his strategic, buy-and-hold portfolio. For the contrarian component, he would regularly rotate into whichever of the firm's funds had underperformed in the short term. When those once-slumping funds recovered, he would cut them loose. Employing such a naïve contrarian strategy not only gave underperforming fund managers a vote of confidence, he said, but the approach had also performed quite well over time.

Although rebalancing is milder, investors also employ a contrarian tilt when they boost the holdings that have slumped in value and lighten up on those that have performed especially well. Rebalancing isn't foolproof, but over time it will tend to reduce risk in a portfolio by prompting the investor to scale back on overvalued market segments and boost their positions in areas that could be due for a rebound.

Today, rebalancers--and anyone in search of values, for that matter--may have their eyes on foreign stocks. Not only have most foreign-stock funds lost just or nearly as much as their U.S. counterparts so far in 2016, but foreign-stock funds have been serial underperformers. The average foreign large-blend fund has posted a slight loss during the past five years, whereas the typical U.S. large-blend fund has gained about 9.4% on an annualized basis during the same five-year period. The MSCI EAFE Index has not bested the S&P 500 in any calendar year since 2012.

But does that mean foreign stocks are cheap? Not necessarily. As senior analyst Kevin McDevitt discussed last year, foreign developed-markets stocks haven't performed badly relative to the U.S. during the past five years. Instead, a major factor behind foreign-stock funds' underperformance has been currency: That is, foreign securities performed fine on their home bourses, but when U.S. investors translate their returns into dollars, their gains shrink or evaporate altogether.

Giving With One Hand ... To review, there are two levers that affect U.S. investors' returns from investing in foreign securities, whether stocks or bonds. First, whether the securities themselves gain or lose value, and second, whether the currencies in which those securities are denominated have gained or lost value relative to the dollar over the U.S. investor's holding period.

It's possible for investors to win on both sides of the ledger at the same time, or to lose. Alternatively, there can be a split decision: The stocks in a foreign country gain in value while the currency in which they're denominated drops in value relative to the dollar. That has been the case with many foreign developed-markets stocks recently.

Given that trend, it's probably not surprising that we've seen a mini-explosion in exchange-traded funds that provide exposure to foreign stocks but hedge their currency exposure back into the dollar. Those funds--and their nonhedged counterparts--provide a helpful illustration of how foreign-stock performance and currency performance can diverge.

In 2015, for example, U.S. investors in

Valuations Tell the Tale Indeed, many developed foreign markets, including the U.K., Germany, France, Italy, and Japan, outperformed the U.S. in 2015, but those gains disappeared once the declines in the euro and yen were factored in.

The fact that foreign stocks have performed decently, even if foreign currencies haven't, was reflected in Morningstar analysts' price/fair value estimates at the end of 2015. Some of the largest developed foreign markets, including the U.K., France, and Japan, were trading at a slight discount to fair value, on a capitalization-weighted basis. But Morningstar analysts' price/fair value estimate for the cap-weighted U.S. market was even lower at the end of 2015, according to research published in Morningstar Markets Observer.

What to Do Does all of this mean that investors should hold off on topping up their allocations to foreign equities if they've slumped? Not necessarily, but their decisions should be nuanced.

First, valuations in many developed foreign markets suggest that if U.S. investors earn strong gains from foreign stocks in the future, currency movements, rather than big gains in underlying security prices, may help drive those gains. Thus, it's possible that investors newly arrived in hedged foreign-stock products could encounter lackluster foreign-security returns and get caught leaning the wrong way on currencies. The difficulty in predicting currency movements, combined with the additional costs that hedging can entail, is why so many professional foreign-stock fund managers stay out of the business altogether. They maintain fully hedged portfolios or, more commonly, don't ever hedge and focus exclusively on security selection.

Moreover, the discussion so far has centered around capitalization-weighted developed-markets indexes. But investors obviously have many more choices when investing overseas. For example, they can invest in a total foreign stock market index fund that encompasses emerging markets. In my recent roundup of return forecasts from various market experts, I noted that the teams at both GMO and Research Affiliates were especially sanguine about the prospects for developing-markets stocks. (The two firms parted ways on the prospects for developed foreign stocks; Research Affiliates is fairly bullish, while GMO is not.) Most active managers of broad foreign-stock funds also give themselves leeway to invest in emerging as well as developed markets.

And if investors are concerned about valuations with developed-markets foreign equities, they might consider focusing on value stocks within that universe. Among Morningstar's favorite, still-open foreign-stock funds with a value bias are