Should You Bother Investing Abroad?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Foreign stocks have underperformed U.S. over the past decade, and some investors may be wondering whether to stay the course. Joining me to share some perspective on that question and a few fund favorites is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's revisit the case for investing overseas. Many U.S. large caps are global businesses, and foreign stocks do bring some risk to the table in that they are denominated in--or may be denominated in--foreign currencies. So, you pick up some risk there. Why should investors still globally diversify their portfolios with foreign stocks?

Bryan: Well, I think, it's really important to diversify internationally because U.S. stocks, while they have had a really strong record over the past 20 years or so, they do go through stretches of underperformance relative to international stocks. And so, even though international stocks do tend to be a little bit more volatile than U.S. stocks because they are priced in foreign currency, if you add a small part of your portfolio and park that in international stocks, that can actually help diversify your local economic risk, it can help diversify interest-rate risk, currency risk. So, when you think about diversification, it's important to think beyond just diversifying across individual stocks, individual sectors, you should also think about diversifying across different markets.

A lot of times people say, "Well, you know, don't I get enough international diversification with U.S. stocks?" It is true that a lot of large-cap U.S. stocks are global. Based on Morningstar data, U.S stocks in the S&P 500 generate about 62% of their revenue in the U.S. But international stocks actually still have less exposure to the U.S. market. If you look at the holdings of Vanguard Total International Stock ETF, they only generated about 15% of their revenue in the U.S. over the past year. So, you do get a lot better market diversification in terms of where the underlying stocks do business by diversifying across both U.S. as well as international stocks.

Benz: So, let's talk about rightsizing positions, rightsizing allocations to foreign stocks. If I look at foreign stocks, they compose a little less than half of the global market capitalization today. Some investors might say that seems like too much foreign. How much home-country bias is reasonable? And how should I sort of approach that question about how to allocate to foreign stocks?

Bryan: So, I think there's not a uniform answer for every investor. It really depends on, I think, your level of risk tolerance. When you do add international stocks, you are going to pick up a little bit of volatility from the currency risk. But I think a small allocation of about a quarter to a third of your portfolio shouldn't have a huge impact on the overall portfolio's volatility because, even though that one piece of your portfolio might be a little bit more volatile, because international stocks aren't perfectly correlated with U.S. stocks, the diversification benefits help offset that added volatility. And overall, it doesn't really increase the risk all that much. But if you are a more conservative investor, you're not quite as comfortable with some of that currency risk, you could consider either allocating a smaller portion of your portfolio to international stocks or going with something like a currency-hedge fund, which tries to strip out the volatility that might come from the currency risk. But I do think it is reasonable for U.S. investors to still have a little bit of a U.S. home-country bias, but even the most conservative investors should probably have a little bit of their assets parked in international stocks.

Benz: So, you touched on the hedging question, the currency risk question, Alex. How should investors approach that question, because now there are very low-cost products that do hedge their foreign-currency exposures? How should investors navigate that? Are they losing anything by going with a hedged U.S. – a hedged international product even though they may be lowering risk?

Bryan: So, the main trade-off here is really twofold. Number one, currency-hedged funds do tend to charge slightly higher expense ratios than unhedged funds. And if you think about currency risk, if you're a long-term investor, currency fluctuations tend to wash out. They, over the very long term, generally don't have a huge impact on returns one way or the other. They do, however, add to some volatility. But if you want to take that risk off the table and you're comfortable paying a slightly higher fee, currency hedging might be a way to go. The other trade-off in addition to higher fees is that currency-hedged products tend to be a little bit less tax-efficient. In other words, they're more likely to make capital gains distributions because they do have to roll their contracts forward, and they may have to realize capital gains in the process. So, it is a little bit less tax-efficient. But if you are more risk-averse, that still might be a good way to go to take some risk off the table.

Benz: And perhaps hold that hedged international fund in some sort of a tax-deferred account where I'm not feeling those extra capital gains distributions?

Bryan: Exactly.

Benz: So, let's get into some ETF picks, perhaps for investors who are revisiting their foreign stock exposures, given that we have seen foreign stocks underperform. Let's start with a very plain-vanilla core type fund. This ticker is VXUS. It's a Vanguard fund.

Bryan: Yes, this is the Vanguard Total International Stock ETF. This one basically owns stocks of all sizes listed outside the U.S. So, it includes both stocks listed in foreign developed as well as emerging markets. So, this is a good one-stop holding for international stocks basically. It gives you everything outside the U.S. I like this one because it's a very low-cost fund. It charges 9 basis points. It's also fairly tax-efficient. It's low turnover. It's never made a capital gain distribution. And it gives you a really good diversification. It has very good diversification across both sectors, region, stocks. So, if you're just kind of looking for a good passive core holding, I think this is a good one to start with.

Benz: Let's look at a smaller-cap international fund that you like. And first, let's talk about the thesis for even looking at small-cap international stocks.

Bryan: I think one of the benefits of investing in international small caps is that small-cap stocks tend to be more highly levered to their local markets than their larger-cap counterparts. So, you do get slightly better diversification benefits, I think, with small-cap stocks than you do with large-cap stocks that happen to be listed in foreign markets. So, I think that's really the main benefit here. Something like Vanguard FTSE All World ex-US Small Cap ETF, ticker is VSS, is one of the cheapest international small-cap funds available. It charges 12 basis points. And it includes stocks that are listed in foreign developed as well as emerging markets. And a lot of the small-cap stocks in emerging markets tend to be more consumer-oriented. They're less likely to be state-owned enterprises. So, you get a little bit more clean exposure to those local markets. So, if you're trying to benefit from some of that growth in emerging markets, I think smaller-cap names are going to give you better exposure to those than some of the larger-cap names that happen to be listed there.

Benz: And finally, let's talk about a fund that does hedge foreign-currency exposure. So, for investors who want to try to reduce the volatility level, the risk level in their international stock holding, let's share an idea for them.

Bryan: Sure. So, Xtrackers MSCI EAFE Hedged Equity, ticker is DBEF, is a good currency-hedged option. Now, this fund only invests in stocks that are listed in foreign developed markets overseas. But I think if you're going to be a currency-hedged investor, it makes sense to really focus on the foreign developed market because the cost of hedging is lower there than it is in emerging markets. One of the factors that determines how expensive it is to hedge is the interest-rate differential between the U.S. and the market where you're looking to hedge. Right now, interest rates in most developed markets are fairly low. So, it's actually pretty inexpensive to hedge your currency risk there. If you were to try to apply a currency hedge in emerging markets, it can be more expensive to do that. But I think this is a really good option for investors who are looking to take some currency risk off the table. Like I mentioned, this does charge a slightly higher fee than some of those unhedged funds that we talked about. This fund charges 35 basis points. That's still fairly low compared to actively managed alternatives, but it is a bit higher than some of those Vanguard funds that we talked about.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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