Should You Add International ETFs to Your Portfolio?

People tend to feel that including international stocks or ETF’s in a portfolio should have real diversification value, meaning that their inclusion will help to limit total portfolio risk. Well, that’s the thinking. But the reality turns out to be a bit more complex. I assembled a list of the oldest international ETFs and looked at their Beta and projected volatility based on the last three years of data (click for larger version):

The value of Beta is preserved from the historical data, but the standard deviation in annual return is projected forward. If market volatility increases, high-Beta assets will tend to increase in volatility more than low-Beta assets.

The two things that one immediately notes about these international ETFs is that most have Beta greater than 100% and all of them have standard deviation of annual return that is dramatically higher than the volatility (the standard deviation in annual return) projected for the S&P500. The only ETF in this list with Beta substantially less than 100% is the global energy ETF (IXC). (The lack of values for ILF is due to the fact that it has not actually been around for three years, so there was insufficient data.)

When we run the Monte Carlo portfolio analysis for a group of tickers that includes all of the ETFs listed above and their underlying indices using three years of data, we get the following result:

The international indices, in general, show far lower values of Beta and far lower values of projected standard deviation than the international ETFs. Many of these international ETFs, when included in a portfolio that is largely comprised of stocks listed in U.S. markets, will actually increase the sensitivity of the portfolio to fluctuations in the U.S. markets.

A prime reason that most investors want international stocks is to diversify risk associated with the U.S. markets, but many of these ETFs will not serve this purpose at all. To the contrary, based on historical volatility and Betas, many of these foreign ETFs look more like aggressive growth investments rather than as vehicles for managing portfolio risk. That explains the extremely high returns that we have seen from these ETFs and similar portfolios in the past several years.

The high Betas and high historical and projected volatilities also serve as a warning that a portfolio with substantial concentrations of these ETFs along with other high-Beta investments such as tech stocks may yield a final portfolio that is over-sensitive to the U.S. market and also carries levels of volatility well beyond an investor’s comfort level.

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