INTERNATIONAL vs US STOCK FUNDS

When we start working with them, most of our customers have some portion of their portfolio invested in international stock funds.  Many investment professionals encourage investors to own international stock funds to diversify their portfolios.  The idea behind this concept is that certain international stock markets may have better growth potential than the US market or may perform better when US markets are down.

But should you invest in international stocks and how much should you invest?

As you know, I am a data geek and a logic nerd.  So, of course, I am going to turn to the data to answer this question. 

The short answer is no.  You should not bother with international stock funds.  Let’s look at the data.

If you’ve read my most recent book, Picking the Best Funds for Your 401K, I explain my decision-making process for evaluating funds or any investment.  Without a rigid and consistent process to evaluate investments, people are using gut and emotions which rarely work.  I am never interested in opinions about investments if they are not backed up by rigorous analysis. 

Here are the three main areas that I use to evaluate any investment.

1. Performance – particularly long-term performance (10 years, 20 years, 30 years).

2. Consistency and Volatility – Consistency equals predictability.

3. Conviction – Knowledge and understanding of an investment and why it should perform well keeps you committed to the investment.

Let’s compare the S&P 500 index funds and the Nasdaq (large cap stocks) as investments against international stock funds by running through my three key criteria.

There are a variety of different international stock funds.  Some focus only on developed countries.  Some focus on emerging markets.  Some focus on particular geographic regions like Europe or Asia.  Most 401K plans only offer one or two international funds.  Today, I am going to use the EFA World Index fund for comparison purposes.  This is a global stock fund that includes companies from all the major international markets except the US.  Emerging market funds perform worse than global stock funds, so I won’t be covering them today.

Performance

Here are the performance statistics for the funds over the last 30 years.

As you can see, the investment performance isn’t even close.

The US large cap funds are the clear winners for long term performance. 

Consistency & Volatility

How did the two funds perform during bear market declines?  This tells us about volatility.

There is not much difference in performance between US and international funds in bear markets.  The international fund does slightly better in bear markets because it pays a higher dividend (3.2% dividend for EFA vs. 1.3% for the S&P and 0.66% for the Nasdaq).

For the most part, international stocks follow the same bull and bear market cycles as US stocks.  So, there is no diversification advantage to owning international stocks.

Conviction

Understanding an investment leads to more conviction in that investment. 

Gold is an example of an investment that I would have no conviction over.  Yes, gold does tend to outperform stocks in bear markets, but it performs so much worse most of the time that you are only going to lose by owning gold in the long run.  If anyone could accurately predict bear markets, then they could get in and out of gold at the appropriate times but nobody can do this.

The key issue here though is conviction.  If you follow gold and the supply and demand story of this commodity, you soon realize that nobody understands what makes gold go up in value or down in value except after the fact.  I could come up with some great stories about why gold has been on such a strong run recently, but anyone that tells you they saw it coming is not being honest. 

When I have no idea why gold goes up or down, I have no conviction.  Gold doesn’t produce any earnings that we can analyze.  It doesn’t pay a dividend. 

Let’s view international funds through that same lense.  The US and international funds are both highly diversified with hundreds of individual stocks making up each fund.  Like the S&P and the Nasdaq, EFA is heavily weighted toward large cap stocks.

The only difference is geography. Both the S&P 500 and the Nasdaq trade on US stock exchanges.  The stocks in the EFA trade on stock exchanges outside the US.  Where a stock trades does not tell you where they do business.  The US funds contain large companies that generate sales all over the world.  Most of the EFA companies are global as well.

So, the difference is mainly where companies are based.  Do US based companies have a competitive advantage?  I believe the answer is a clear yes. 

My international customers might disagree with my answer, but the data is very clear.  The US market has produced the best performing and most innovative companies in the world and it continues to do so.

Some of my international friends say that the historical performance does not guarantee future performance.  I agree.  But where are the signs of global economies producing the best companies in free markets.  China can produce excellent companies in a nationalized economy, but China has many risks that the US does not have. 

I am also not saying that there are no great companies outside the US.  There are just not enough of them to make up a large cap index fund that matches the US large cap funds. 

Things can obviously change in the future but based on what we know today - which companies or economies do you see winning over the next 20 years?  Do you really think the global stocks are going to start producing double digit annual gains to compete with the US funds when they are only growing at 5% per year now?

One of our subscribers who doesn’t agree with my position argues that the Swiss market beat the US market over a period of several years.  I didn’t find any evidence of this, but we could all find a stock or a fund that beats the US large cap funds over small periods of time. But if they fail to outperform in the long run, does it matter?  You would have had to know which markets or funds were going to outperform in advance to take advantage of these rare situations.  And you would need to know the exact time to get out of that market when it went back to underperforming.  I don’t know anyone who has a crystal ball that can predict the winning markets and the exact timing in advance.

Another Risk Factor – Currency Risk

When you own stocks that trade outside the US, you also face currency risk. 

Let’s say that a group of global stocks outperformed the US funds by 2% in a particular time period.  If the exchange rates became unfavorable, you would come up short when you exchange those stocks for dollars.  The opposite is also true where the currency translation might work out in your favor.  I find playing the currency markets to be more difficult than investing in stocks.  US investors buying US funds do not face any currency risks.

I like to play the long game where the odds are in my favor.  As of right now, I don’t see any developments on the horizon that would indicate that international stocks will beat the S&P 500 or the Nasdaq over the long term.  In fact, the data suggests that any money invested in international funds will cut my returns in half. 

When your financial advisor tells you that you need international exposure, show them this information and ask them what they could possibly be thinking? 

Stay Disciplined My Friends,

Phil

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Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.