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Are You Questioning Your Foreign Stock Funds?

Why these funds are struggling and what to do about it.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi. I'm Christine Benz from Morningstar. The year 2020 has been a volatile one so far for investors, and that includes investors in foreign stock funds. Joining me to provide a recap of the first half for foreign stock fund investors is Dan Sotiroff. He's a passive strategies research analyst for Morningstar. Dan, thank you so much for being here.

Dan Sotiroff: Hey, Christine.

Benz: Dan, let's get right into performance and talk about how foreign stock funds have performed relative to U.S. stock during the first half so far.

Sotiroff: Well, generally, they haven't performed as well. You got to break it up into a couple areas. So we're filming this--it's June 25 right now. So, if we're looking back from Jan. 1, more or less through the first half of the year, foreign stock has sort of lagged the U.S. by a little bit. That hasn't really been all because of typical things like you would think. The dollar has continued to appreciate, that's hurt it a little bit, but it's really just the local market stock returns that have kind of hurt it. They've underperformed by around 6%-7% in aggregate. That's sort of just a continuing story of what we've seen over the past 10, 11 years. Foreign stocks have generally lagged their U.S. counterparts pretty broadly.

Benz: Some of the issue may simply be that there aren't FANG-equivalents overseas, that that's part of what's been driving the U.S. market in those big technology names ... there aren't analogous leaders in foreign indexes, correct?

Sotiroff: Yeah, that's right. When we did the analysis, and I've got something that's going to be published here in a few weeks, but when we ran the numbers... The continuing story I kind of hear is that this is kind of a sector play when you look at sector differences across countries. That's certainly true; however, the sector differences didn't really account for a lot of the return difference when you ran an attribution. Really what it came down to was what you're saying, it's really the individual companies in the U.S. versus their foreign counterparts that are really doing, or I should say, are really responsible for a lot of the performance gaps. So, in the U.S. we've got the Microsofts, the Apples, the Netflix that have had really strong performance over the past decade. They're U.S. companies, they don't exist overseas, so that's been a big part of the gap between the U.S. and foreign markets.

Benz: Let's drill into various subsectors within foreign markets, starting with value versus growth. In the U.S., we've obviously had this long-running bifurcation with growth stocks dramatically outperforming value. Does that carry over overseas into those markets as well?

Sotiroff: Absolutely, and we've seen it in the first half of this year, as well. Value stocks have just gotten trounced, and growth has actually held up pretty well, and the performance from overseas growth stocks has actually been comparable to the U.S. market. We've got a couple of funds that track those indexes, or I shouldn't say track those indexes, but they follow those styles. They've held up consistent with what you would expect from that sort of performance bifurcation, I guess you can put it.

Benz: How about international small caps?

Sotiroff: Small caps--they've been back and forth. Obviously, these are high beta stocks, so they've generally performed pretty poorly over the past six months, which is kind of what you would expect. They're a little more levered to their local economies. They don't have sort of the competitive advantages of their larger counterparts. So, their drawdown was a little bit steeper during the coronavirus sell-off, which is consistent with what you would expect. The other thing with small caps is they tend to have a lot more exposure to things like energy and materials. So, those sorts of sector plays tend not to be great, especially when you go through sort of this energy drawdown that we saw coinciding with the coronavirus sell-off. So, they've had a tough go of it over the past six months and really over the last few years, as well.

Benz: How about the low-volatility strategies? I know a lot of investors have gravitated to them for the expectation that they would hold their ground in an environment like what we had in the first quarter. How did they hold up during that difficult period?

Sotiroff: They did a little bit better. Again, consistent with what we saw in small caps, they did kind of what you would expect. They took some risk off the table; their drawdowns weren't as deep. I realize that's kind of a shallow statement when you went through a drawdown as big as we saw during the first quarter, but they generally did. They took some volatility off the table. Their drawdowns weren't as deep, and they delivered as intended and as promised. So, as far as validating their thesis, they did exactly what we would have expected them to do.

Benz: What are you seeing with fund flows in a period in which foreign stocks have underperformed U.S.? Are we seeing investors take some chips off the table there and sell foreign stock funds?

Sotiroff: Over the last two to three months we've actually seen some pretty big outflows in foreign stocks broadly. That includes both developed and emerging markets. What's interesting about this sort of outflow over the past few months is that it ... For the past, I'd say probably 10 years or so, you've seen a lot of movement out of active and into passive strategies. This outflow--it didn't really matter. Investors were pulling money from both active and passive strategies, almost, depending on the market you were looking at, it was sort of equally weighted between the two. So, it really to me says this is sort of a risk-off sort of outflow type thing. People, I think, are just sort of getting fed up with the poor performance from foreign markets. At least that's what the data would seem to indicate.

Benz: Well, that's what I'd like you to speak to. I think you're right that a lot of investors do feel a little bit fed up with their foreign stock allocations. It's been quite a while since we've seen foreign stocks outperform U.S., at least for an extended period. So, how do you counsel investors to think about this and to keep the faith in a globally diversified portfolio? What's the case for foreign stock holdings at this point?

Sotiroff: It's really tough. I'll agree with you. The performance has not been great. It's been a very, very long slug of just underperforming the U.S. market. It's difficult to justify, understandably, but I always remember that markets can't go one direction forever. Sooner or later, valuations have to come into play at some point, right? So, right now you've seen foreign markets underperform for over a decade. Their valuations are understandably lower than they are in the U.S. Myself, I'm just following a strict rebalancing strategy. Like we say every time we sit down for these videos, I'm going to be buying more foreign stock when I go to rebalance my portfolio. Over the long run, the next 20, 30 years, whatever your time horizon is, I think that's going to be a pretty good strategy. It's worked out historically, and I'm very confident that it's going to continue to work out very well in the long-term future

Benz: Dan, great points. Always great to get your perspective. Thank you so much for being here.

Sotiroff: Thank you, Christine.

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