Investors Should Stick With Foreign Stock Index Funds

Christine Benz: Many investors expect that index funds will outperform active funds over time, but that hasn't been the case with foreign stock index funds recently. Joining me to discuss that phenomenon is Dan Sotiroff. He is an analyst in Morningstar's passive strategies research group.

Dan, thank you so much for being here.

Dan Sotiroff: Hi, Christine.

Benz: Dan, you wrote a piece about this, this summer. When you look at foreign stock index fund performance relative to category averages, it's been a little bit so-so recently.

Sotiroff: Little Lacking, right.

Benz: Let's talk about that phenomenon. I think perhaps it's shaken investors' faith in foreign stock index funds. Let's just talk about what's been going on there.

Sotiroff: What you've seen over the past eight to 10 years, coming out of the financial crisis, is foreign stock market indexes, index funds that track these indexes, they haven't performed as well as the U.S., they haven't performed as well by historic standards. If we go back over the last few decades, obviously, Japan was a big constituent and it hasn't been a great market …

Benz: In the index funds.

Sotiroff: Right, in the index. As we come to, like, 2008, 2009, 2010, Japan's weight came down, but index funds still haven't been among the best performers in the category. They have been in that middle third of the category on a Sharpe Ratio or risk-adjusted basis. The question is, what is going on here, the low fee thesis should intact--lower fees should lead to better performers over the long run, right? It's been eight to 10 years now and it's a question mark that a lot of people are looking at.

The big thing I would point to is that you are tracking a market index. So, when you are tracking a market index, you are going to end up with whatever the market does.

Benz: You are fully invested.

Sotiroff: Correct. So, you are fully invested all the time. What you see over the past eight to 10 years is some of the better performers in those categories have been things like the more defensive funds--anything particularly over the last five years that had a currency hedge on it, defensive funds that had less exposure to the market beta or market risk as a whole …

Benz: So, these are active funds that have made bets. They have hedged their foreign currency exposure into the dollar. They have been defensive in some fashion.

Sotiroff: Some of these are just passive funds, too. So, we have some index trackers that also have currency hedging strategies. We have some strategic beta funds that intentionally go after less-risky stocks or they take a less risky approach to investing in the market. So, those funds, in general, have done actually much better than the category average and they have actually been some of the leaders over the past eight to 10 years. In general, though, what this gets at is the concept of Dunn's Law.

Benz: And explain what that is.

Sotiroff: Dunn's Law basically tells us that when a market does well, an index fund tends to better relative to the peers in that category, because its fee is so much lower. It doesn't have this constant drag on returns that you get with a higher-cost active fund. That's the basic concept.

My colleagues did some work on this earlier this year. They generally found it to be true in most markets. And the analog or the opposite of that has been happening in foreign markets where you've had these tepid returns relative to their longer histories. When the market doesn't do well, you are seeing index funds do so-so type of performance. That's really what you see going on here. And there's other strings that active managers can pull around the edges to improve their performance when the market as a whole isn't doing very well.

Benz: I think some investors may have their confidence shaken in foreign index funds. They might be looking at their U.S. products and saying that's a good place to index; foreign stocks, maybe I'm not so sure. Would you say that the fact that index funds have not looked so good for the reasons that you mentioned, is that a reason to revisit the thesis behind being invested in index funds overseas?

Sotiroff: No, because here is the thing. When you look at the U.S., though U.S. has gone through these stretches, too, where index funds didn't look great relative to the active peers. We are kind of in that stretch right now with foreign stocks. The one thing it all comes back to at the end of the day is fees. Over and over and over again we hear this story, we see the data in our active/passive barometer--fees are one of the biggest drivers of future returns. The low fee thesis is still very much intact. Investors in these funds just need to sit tight and hold on. Eventually, we will get through it. I'm very, very confident in that.

Benz: By the same token though, some of the more finely tuned foreign stock products that you talked about, like perhaps a low-volatility product or maybe one that's hedged into the dollar, those can make sense for certain investors, right?

Sotiroff: They absolutely can make sense. What's been great about some of those products is the fees has come down on those with the overall fee pressure and competitive pressure. We actually have some very low-cost options that we evaluate and that we regularly put on Morningstar.com. Investors should really check those out. And as always, those are really best served with very long-term holding period, like you would with a core fund, like some of the market trackers that we've been discussing today.

Benz: Interesting research, Dan. Thank you so much for being here to share it with us.

Sotiroff: Thank you.

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