The reality behind some common misconceptions that may be keeping investors out of international stocksNew research from Fidelity Viewpoints. Reprinted with permission. Visit here.
April 18, 2017 — While many investors have taken advantage of the six-year rally in U.S. stocks, they may have overlooked attractive opportunities overseas.
Despite the recent struggles of some international markets, there are powerful reasons to look outside the U.S. for stock investments, such as enhanced diversification, the potential for better risk-adjusted returns, and more.
Nevertheless, many investor portfolios remain underexposed to international stocks, often due to misperceptions about these investments. So here are Fidelity’s responses to five common “myths” investors have about investing in international stocks.
Myth 1: International investing is too risky
Reality: In combination with U.S. stocks, international exposure can actually lower risk in a stock portfolio. Over the past 65 years, a globally balanced hypothetical portfolio of 70% U.S./30% international stocks has produced better risk-adjusted returns (Sharpe ratio)1 and lower volatility (standard deviation) than an all-U.S. portfolio (see chart below, left). The 70/30 relationship has fared worse over the past decade or so (see chart below, right), but we believe it may revert to its historical norms given the cyclicality of U.S. and international stock market performance.
Myth 2: U.S. stocks usually outperform foreign stocks
Reality: Historically, the performance of international and U.S. stocks is cyclical: One typically outperforms the other for several years before the cycle rotates.
Recent performance has favored U.S. stocks, but given the cyclical pattern of performance, foreign stocks will likely take the lead again, eventually. Timing these rotations is difficult, though, so investors who are underexposed to international could miss significant gains when the market corrects. Note also that in each of the last 12 calendar years, the best-performing single country stock index has been outside the U.S., and the top-performing stock in nine out of 10 market sectors during the past decade belonged to international companies.2 This illustrates the value of maintaining international exposure in any market environment.
Even when the cycle of performance favors the U.S., foreign markets can still offer higher returns.
Myth 3: U.S. multinationals provide adequate international diversification
Reality: Over the years, many large U.S. companies with operations overseas have experienced periods when their stock prices have been highly correlated to the performance of the S&P 500. High correlations indicate that investment returns are moving in tandem and typically signal lower diversification. The correlations between major U.S.-based multinationals and the S&P 500 have declined in recent years, but this doesn’t necessarily make them good replacements for international stocks in a U.S. investor’s portfolio.
The chart below compares the average correlations of several U.S. multinationals in different sectors to international counterparts with U.S.-listed shares. The international stocks shown here have offered lower correlations to the S&P 500 over the past three years, which typically signals better diversification benefits. And while U.S. multinationals may provide some exposure to foreign markets, they still offer only a fraction of the currency diversification that can be achieved by investing directly in overseas markets.
International stocks can provide more diversification benefits than U.S. multinationals
Myth 4: Investors should hedge their currency exposure
Reality: Currency hedging involves holding a stock denominated in a foreign currency and an equal but opposite position in the currency itself. This is intended to prevent currency fluctuations from hurting the stock price. While it sounds good in theory, the effort and expense involved might not be worth it. Timing currency calls is very difficult, even for professional investors. And currency tends to be a relatively small component of returns.
Historically, earnings growth and price-to-earnings ratios have been far bigger drivers of performance. Most important, currency hedging does not pay off over time. Since 1973, currency hedging has detracted from returns in 50% of quarters, and helped in 50% of quarters (see chart below). And during that same period, the unhedged MSCI EAFE Index has actually beaten the local-currency-denominated (hedged) EAFE by 1.09% on an annualized basis.
Historically, hedging currency has hurt returns about as often as it’s helped them.
Quarterly returns of MSCI EAFE USD Index vs. MSCI EAFE Local Currency Index 1973-2015. Source: Morningstar, Fidelity Investments, as of December 31, 2015. Past performance is no guarantee of future results.
Myth 5: Index funds have beaten active funds in international
Reality: An index fund provides exposure to all available companies—good and bad—in a particular investment universe. By contrast, active managers backed by skilled research analysts have the ability to select (or avoid) specific companies they believe will beat (or lag) the index average.
This is especially notable because company selection is the biggest driver of equity returns—twice as important as country or sector selection (see chart, right). The ability to pinpoint specific opportunities may explain why the average actively managed large-cap international fund has beaten its benchmark index by 0.86% annually, even after fees. In comparison, the average large-cap international index fund has trailed its benchmark by 0.32%.3
That’s a difference of 1.18% per year in favor of active funds. And when you consider the power of compounding, it’s clear that actively managed international funds may offer more growth potential than index funds alone.
International exposure is an essential component of the stock portion of a balanced portfolio, and it’s important not to let myths and misconceptions derail a sound asset allocation strategy. Given this, here are several important considerations about the six-year bull run in U.S. stocks:
- It won’t last forever;
- Investors may now have too much U.S. equity exposure, which could increase portfolio risk; and
- We may be seeing the early signs of recovery in a number of markets abroad. (For details on the outlook for global markets, read the latest market update.)
For individual investors, now may be an ideal time to reexamine their stock allocations to see if it makes sense to add more international equities to their investment mix.
Investing in companies overseas comes with political, liquidity, and currency risks, all of which can create price inefficiencies within individual stocks, sectors, or countries.
Capitalizing on these inefficiencies requires specialized local knowledge, careful research, and efficient trading. Active managers by definition can maneuver a portfolio to take advantage of these inefficiencies, and potentially produce greater excess return compared with their benchmarks and passive strategies.
- Find Fidelity international funds.
- Find out more about Fidelity’s view on active management and some of Fidelity’s top fund managers.
- Find other international funds, ETFs, and individual stocks.
Fidelity’s Investment Product Vice President Matthew Godfrey, Investment Product Directors Wilson St. Pierre and Cheri Kotlik, Asset Allocation Research Team Senior Analyst Jacob Weinstein, and Thought Leadership Vice President Matt Bennett contributed to this report.
1. See Glossary of Terms.
2. FactSet, as of Dec. 31, 2015.
3. Fidelity Investments, “U.S. Large-Cap Equity: Can Simple Filters Help Investors Find Better-Performing Actively Managed Funds?” May 2015.