What’s the Correct Exposure to Foreign Stocks?

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[dropcap]L[/dropcap]ately, there has been a lot of noise in the investment world about how increasing globalization has eliminated the diversification benefit to owning foreign stocks. Don’t believe it. Foreign stocks will continue to provide diversification and are part of any efficient portfolio.

Twenty years after the peak of Japan’s real estate and asset bubble in the late 80’s, their stock market remains down over 50 percent, even as the rest of the world has done very well. Will we become another Japan after our real estate bubble? Probably not, but some diversification outside of the US still makes a lot of sense.

But how much is the right amount, and how should you get the exposure?

Here is a look at the annual returns and standard deviations of some S&P 500 and EAFE blends.

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Although the differences are modest, we see that the 75/25 US to foreign blend had the highest return AND the lowest volatility of these choices. Higher return coupled with lower volatility is very rare and very desirable.

For the last decade, foreign stocks have generally outperformed. Thus, it has become a common notion that foreign, and especially emerging markets, is a better investment. Much the same was said about the US at the end of the 1990s. In my opinion, there is no good reason to think one will do better than the other over very long periods of time.

Some people point to the higher volatility of foreign stocks as a reason why they should provide higher returns. But the reason for the higher volatility is because of currency fluctuations, not the stocks. As the dollar goes up and down relative to other currencies, it reduces or increases the returns of foreign stocks for US investors. This leads to more volatility.

The bottom line is that for very long periods of time, return expectations for foreign and domestic stocks should be essentially the same.

This gives us the following logic to build from:

  1. Foreign and domestic stocks are highly, but non-perfectly correlated;
  2. Their long-term return expectations should be about the same;
  3. Volatility is slightly higher for foreign stocks.

Using these, portfolio theory dictates that rational investors should own some blend of the two, with a heavier weighting toward US stocks. This sounds about right. In my opinion, foreign stocks should represent about 30 percent of total equity exposure for most US investors. This is enough to get most of the diversification benefit without taking too much risk if the US dollar goes on a long run of appreciation.

Anything in the 20 percent to 50 percent range makes sense for most people. As of this writing, about 40 percent of the value of global stocks is in US companies. This means my recommendation significantly underweights the US relative to the global market. But I think this is better for US investors who are concerned with dollar based returns. Those who will do much of their future spending in other currencies should own more foreign.

What to Own

Because the main point of owning foreign stocks is to benefit from diversification, it follows the foreign part of most portfolios should be diversified as well. This means owning stocks from different countries and sectors as well as owning different styles.

Luckily, it is now very easy and cheap to own a diversified foreign equity portfolio. In fact, you can own a good representation of the whole foreign market by buying one ETF, preferably Vanguard’s VEU. In itself, this is a good strategy.

Ideally, you would seek to create a slightly more efficient foreign portfolio by blending a few things together. You can customize the Emerging Markets weight by blending ETFs that represent only the Developed Markets and Emerging Markets. Additionally, you can increase small cap exposure buy also owning a chunk of a foreign small cap ETF.

Blending these three is sufficient for most people, but there are a nearly infinite number of ways to combine parts of the foreign market using ETFs, including specific country exposure. For the sophisticated investor, even more efficient portfolios can be built.

Creating a foreign portfolio using individual stocks can be done, but is challenging for most individual investors. There are a several hundred “ADRs”, or American Depository Receipts. These are shares which trade on US exchanges which represent shares of foreign companies on foreign exchanges. They work perfectly well at almost no additional cost. It is possible to build a portfolio from them, but the universe is somewhat limited. Worse, because of all the SEC regulations that are required, the trend is for fewer companies to issue ADRs, not more.

Some brokers, such as Schwab, are beginning to allow individual investors to buy foreign stocks directly on the foreign exchanges. This is a great development, and one that is long overdue. But it raises a whole host of issues that most people are not equipped to deal with, including managing the foreign currencies to make the purchases.

Due to the structure of tax treaties with foreign countries, it is often possible to get a refund for taxes paid on foreign dividends in taxable accounts. These can’t be recouped in tax-deferred retirement accounts. For this reason, it is slightly better to own foreign stocks in taxable accounts. But don’t get too carried away with this – it is good to have some foreign exposure in all accounts.

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

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