Why Your International Allocation May Be Crucial

Includes: DXJ, VOO, VT
by: Tom Madell

While most stock ETF returns have been exceptional over the last 12 months, you may find that your stock ETF portfolio as a whole has delivered somewhat disappointing returns over the last 5 years. While the financial crisis that began in 2007 appears to have been a big reason, investors should realize that international stocks were far more impacted than U.S. stocks and are still struggling to return to pre-crisis levels. As a result, investments allocated abroad since mid-2007 have badly underperformed U.S. stocks, pulling down overall portfolio returns.

For U.S. investors who invest abroad, how well international stocks do looking forward will likely play a big role, as they have in the last decade, in determining whether one's overall returns will normalize or continue to lag historical averages. While relatively high allocations to international stock ETFs have detracted from returns over the last 5 years, the time may be near to expect such allocations will enhance portfolio returns.

There is good reason to hold international stocks except perhaps for the most conservative of investors. Mainly, such holdings provide diversification in the event the U.S. market underperforms or international stocks are able to do significantly better than domestic ones, boosting your overall returns.

Of course, the reverse may continue to be true. But by diversifying, you are attempting to lessen your risks by gaining exposure to more markets than just one. It is the same principle as why one typically is prudent to invest in at least a handful of individual stocks, rather than in just one or two.

It has been pointed out innumerable times that, lately at least, when U.S. stocks run into trouble, international stocks haven't proven to be much of a buffer. Thus, during the stock meltdown in 2008, while the S&P 500 index sank 37%, the average international stock mutual fund dived over 44%. However, during the worst year of the prior bear market, in 2002, the S&P was down about 22% while the average international fund fell a lesser 16%.

Over long periods of time, say 10 years or more, U.S. results should likely not vary by a great deal from international performance, with perhaps a slim advantage to the latter, especially if faster growing emerging markets are included. This has been the case since mid-2003; through May, the average annualized 10 year return for international funds has been a tad better than the S&P 500 (8.1 vs. 7.6%). But such results mask a very important fact:

Over periods of 5 years or even longer, it is surprising how much the performance of U.S. stocks has at times differed from that of international stocks. In fact, going back to late June 2008, the S&P 500 has outpaced the performance of the average international stock fund by about 7% per year. Yet, to the contrary, from mid-2003 to mid-2008, the average international stock fund returned a whopping annualized 16.1 vs. the S&P's 7.6%.

Look, for example, at the holdings of an ETF that holds stocks from all over the world, including the U.S., the Vanguard Total World Stock Index ETF (NYSEARCA:VT). What stocks might you expect to be included in its 10 largest holdings? None other than Apple (NASDAQ:AAPL), Exxon Mobil (NYSE:XOM), Microsoft (NASDAQ:MSFT), General Electric (NYSE:GE), Chevron (NYSE:CVX), Google (NASDAQ:GOOG), International Business Machines (NYSE:IBM), Johnson & Johnson (NYSE:JNJ), Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), and Wells Fargo & Co. (NYSE:WFC). Sorry to say for those trying to diversify away from the U.S., but only Royal Dutch Shell is located outside of the U.S. Therefore, surprisingly, if you own both an S&P 500 index ETF, such as VOO, along with VT, the top 8 largest holdings are currently the same.

Given the broad diversification afforded by many such global ETFs, if one wanted to own just one single fund without perhaps the need to own other stock funds, such a fund might be the way to go. But to do so, one would have to fully embrace stocks from all over the world in the regional percentages contained within the ETFs portfolio. Thus, VT currently contains only about 50% U.S. stocks with the remaining 50% from foreign countries, including 10% from emerging markets.

Since many U.S. investors might feel uncomfortable with such large foreign allocations, a better way to go for them might be some combination of perhaps U.S.-only and foreign funds, allowing for a varying percentage of domestic vs. foreign stocks. Although there is no one agreed upon "best" allocation between U.S. and foreign stocks within a portfolio, many would suggest a foreign percentage typically ranging from 20 to 40%.

If your portfolio puts you in or near this range, it may be quite well diversified, but there is still a problem which may not immediately be apparent: How can you determine how well your overall stock portfolio, considering the totality of your holdings, is doing as compared to some standard? (i.e., is it performing satisfactorily or is it underperforming? Or, has your advisor or newsletter done a good job for you or would you have done noticeably better with different choices?)

U.S. investors, such as myself, typically compare how well our entire stock portfolio did over given periods in relation to the S&P 500 index. Using this comparison may make sense because most U.S. investors likely do have the majority of their investments in U.S. stock ETFs/funds, so that index is a popular, widely available basis of comparison.

However, when you have chosen to have at least some of your fund investments in international stocks, does it still make sense to compare your overall performance to the S&P 500 index which is made up only of U.S. stocks? This has been a very important issue over the last 10 years because foreign stocks may have either considerably hurt or considerably helped your portfolio's performance vis-a-vis the S&P 500 index over different time periods.

If domestic stocks are doing better than foreign stocks over an extended period as over the last 5 years, the S&P will likely consistently outperform your globally diversified portfolio. (This assumes your specific fund choices do not depart drastically from their peers.) In examining your results, you may have concluded that somehow you (or your advisor or newsletter), were on the wrong track. But if you invest internationally and compare your portfolio results to the S&P 500, the only thing that may be wrong is using the wrong index.

And when foreign stock indexes are doing better over an extended period as compared to U.S. stocks indexes, the reverse will be true: Your worldwide portfolio will typically show that it is beating the S&P 500 index.

Of course, the larger your allocation to international stocks, the more your portfolio will be subject to this effect. That is, someone's portfolio with a 40% allocation to such stocks will suffer a bigger underperformance as compared to the S&P 500 than someone with a 20% allocation, and reap a bigger benefit, if such stocks outperform.

Therefore, rather than using the S&P 500 index to judge how well a mixed portfolio of U.S. and foreign stocks is doing, it makes more sense to measure a worldwide portfolio of stocks against a similarly composed worldwide index. Otherwise, you may realize either trailing (or market-beating) portfolio performance solely because you chose to include a 20 to 40% range of foreign allocation in your portfolio, and not because of any other reason.

Your International Allocations May Determine If Your Stock Portfolio is Ahead or Behind

The data that I will now present illustrate just how important your international allocations can be in getting an accurate picture of how well your portfolio has done over the last 10 years. It uses actual results from the Model Stock Portfolios presented in my Newsletters over the period. More importantly, it shows just how highly significant your future allocations to international funds can be if you wish to maximize your returns going forward.

Up until the start of the Oct. 2007 bear market, my prior overall Model Stock Portfolio returns, when allocated as I recommended, quite typically came out ahead of the S&P 500. The average outperformance of my recommended fund categories was about 4% over 1 year periods and about 5% per year over 5 year periods. These results can be reviewed by visiting an archived page from my Newsletter that was published in 2007.

But for the nearly 5 years of performance data available since then, I have found it harder and harder to beat the S&P 500. For example, by the end of the Sept. 2008, my overall 4th Quarter 2007 Model Stock Portfolio trailed the S&P 500 by 3.8% over the prior year. What had happened to help cause this as well as other disappointing underperformances of my Portfolios' stock recommendations?

What I have said above provides the answer. International stocks, which comprised 35% of my Model Stock Portfolio back near the end of '07 performed far more poorly than domestic stocks. The 35% of my portfolio invested abroad brought its performance down significantly.

The average international stock fund declined by more than 30% between Oct. '07 and Sept. '08; while the S&P also declined, the decline was considerably less severe at 22%. Thus, it turns out the 8+% difference between the U.S. and foreign stock fund performance accounted for the lion's share of my portfolio's underperformance. Of course, portfolio underperformance might have reflected poor choices of specific domestic and international funds to include, but this did not seem to be the case.

As noted above, the outperformance of domestic funds over international funds has continued long term since then. As a result, any portfolio which included the typically recommended range in international stocks down through the years as mine has (and perhaps yours as well) found it extremely difficult to beat the S&P 500.

That is one reason why beginning in mid-2008, I gradually began dropping my allocation to foreign stocks to as low as 20% in Jan. 2011 and have kept them mostly low ever since. In 2011 alone, the S&P outperformed foreign stocks by 15.5% (+2.1 vs. -13.4%), so that a low allocation internationally kept my portfolio from otherwise doing worse.

In the calendar years 2002 thru 2007, by contrast, international stocks were always significantly ahead of the S&P. Therefore, with my allocations to international stocks during those years averaging about 30%, we highly consistently beat the index on a one, three and five year basis.

Looking Forward

In 2012, the average international stock fund actually outperformed the S&P, 17.7 vs. 16.0%. Since international stocks now look like good candidates for doing better than many categories of U.S. stocks according to my proprietary research model, with the exception of emerging markets, investors may be able to improve their longer-term future returns by increasing their allocation to these highly undervalued funds.

On the other side of the coin, international stocks have had a rocky first 6 months of 2013. It may indeed be too early to start to increase allocations to your international stocks, especially if you want good results immediately. Cautious investors therefore might want to wait for more signs of improvement in non-US world economies and stock performances before making such a change. However, investors with an eye toward doing well as measured several years down the road, and able to ride out possible short-term setbacks, appear to have excellent opportunities now in international ETFs.

One ETF that more aggressive investors might check into owning is WisdomTree Japan Hedged Equity (NYSEARCA:DXJ) because it can profit from a potential improvements in Japanese fundamentals while not having those gains lessened if the yen continues weakening. By the same token, fund investors who do opt for a less aggressive worldwide mutual fund might favor a hedged fund with an outstanding record, Tweedy, Browne Global Value (MUTF:TBGVX).

In summary, whatever the future may hold, it makes sense to very carefully consider what your foreign allocation will be and to consider altering it at times, based on the ongoing longer-term trends, as a strategy to enhance your portfolio returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.