Investing Beyond the Boundaries
- The majority of the world's investment opportunities are from outside the United States.
- International exposure—to both developed and emerging markets—can have a place in nearly all portfolios that seek long-term growth and can actually help reduce overall portfolio risk.
- An easy way to gain international exposure is through indexed or actively managed mutual funds included in Schwab’s Mutual Fund OneSource Select List®.
When it comes to geographic diversification, many U.S. investors seem to be more comfortable keeping it close to home. Although this is changing due to increasing globalization and more ways to access international markets, many investors continue to be biased toward U.S. stocks. While it's true that sometimes investing beyond our borders can be vexing—for instance, as it was during most of 2011—it can also be rewarding, particularly in the context of a diversified portfolio.
Over the past five years, both developed and emerging international markets, as asset classes, have variously outperformed, underperformed and moved in lock step with U.S. markets, demonstrating not only high levels of volatility, but varying correlations with one another. In Europe, during that period, a financial crisis severely dampened investor confidence. In emerging markets, rising interest rates led markets to underperform. For what it's worth, both situations have stabilized to a large degree, but that's not to say such conditions—or others—won't arise again.
Given such evidence, it may seem that international investing is only for the intrepid. In fact, however, international exposure can have a place in nearly every portfolio that seeks long-term growth. Yes, there are risks, but there are also strong arguments to be made for international investing. We address some of them here.
It's a Big World
The U.S. stock market is still the world's largest, but it constitutes only roughly a third of the world's $53 trillion stock market capitalization.1 Investors who choose to avoid international stocks, therefore, are missing out on a literal world of opportunity: More than 100 countries offer publicly traded investable securities, representing more than 47,000 individual companies worldwide.2 Of those, just over 4,100 are U.S.–based and listed on U.S. exchanges.3
Although international investing does entail additional risks, it also offers the potential for enhanced performance. Across developed markets over the 44 years from 1970 through 2013, not once did the U.S. rank as the best performer. Not only that, in 1993 the U.S. was the worst performer. Within just the past 10 years, the gap between the U.S.'s performance and that of the best-performing developed market was as wide as 61%.4
Developed vs. Emerging
When discussing international investing, it's important to understand the distinctions between developed and emerging markets. Developed markets account for a majority of the foreign stock universe—63% by market capitalization as of 2013 year-end.5 Developed international market countries tend to have higher average incomes, more mature economies, and larger and more liquid stock markets. As measured by the MSCI EAFE Index, developed markets comprise 21 countries, ranging from Japan and United Kingdom—the index's largest constituents—to Singapore and Belgium, its smallest.
Emerging markets, as tracked by the MSCI Emerging Markets Index, comprise 23 countries, including Brazil, the Czech Republic, Mexico and the United Arab Emirates. Although their economies are less mature and their stock markets often constrained, some emerging markets may exhibit better growth opportunities than developed markets. Many have lower debt levels than some developed countries. In addition, emerging market populations tend to have low income bases from which to grow, youthful demographics, natural resources and, in many cases, modest levels of public- and private-sector debt. Those opportunities, however, come with additional risks—even beyond those of international developed markets.
The Diversification Benefit
Historically, one of the most appealing aspects of international investing has been the diversification benefit it can offer. Because international and domestic stocks tend to respond differently to various market cycles and events, their movement is often uncorrelated. This is also often the case between developed international and emerging markets stocks.
Examining the annual performance of developed international markets, emerging markets, U.S. large-cap equities and U.S. small-cap equities over the past five years shows significant divergence not only between the best- and worst-performing asset class, but in the performance of a single asset class from one year to the next:
Digging deeper, correlations among countries are also often quite low, as the factors and conditions that drive performance can vary significantly from one country to another. Take a look at the best- and worst-performing countries among both developed and emerging markets over the past five years and the variance between them:
The Currency Factor
International investments come with a further layer of both diversification and potential return: currency exchange. Downward pressure on the U.S. dollar relative to other currencies raises foreign market returns, diminishing U.S. stock markets' relative performance. Conversely, a strong U.S. dollar shifts the currency advantage to domestic stocks. Because foreign exchange is constantly in play, by investing across various currencies in an appropriately balanced portfolio, investors can further diversify their risk.
Putting It All Together
It's impossible, of course, to accurately predict which country—or even which asset class—will be the best or worst performer from year to year. All of these statistics, however, support Schwab's—and many others'—position that despite the risks and volatility, international investments can enhance a portfolio. In fact, by adding international exposure to a primarily domestic portfolio, investors can actually reduce their risk over time by modulating the spikes and dips of any particular asset class or region.
Over just the previous year, weak emerging markets returns in 2013 along with strong international developed markets and even stronger U.S. stock-market performance may have skewed your asset allocation as compared to your target. Over multiple years, it may have drifted even further. If you haven't done so lately, take a look at your current asset allocation and exposures. If any asset class is under- or overweighted by more than 5%, it's probably time to rebalance. Also look at how much of your international equity exposure is in small-caps and emerging markets. Depending on your risk tolerance, Schwab's general guidance is that investors allocate between 5% and 25% of their equity portfolio internationally, including a small exposure to emerging markets—no more than 5% for the most aggressive investors and less for others.
Although investing in foreign markets can be complicated, an easy way to gain exposure is through mutual funds. Investing in broad-based international funds—either index or actively managed—provides instant international diversification. If you find you need to increase or adjust your international exposure, consider the international funds included in Schwab's Mutual Fund OneSource Select List®.You'll find both index and actively managed funds across a number of Morningstar categories. One caveat: Some international funds straddle categories. For instance, a large-cap diversified fund may have some exposure to emerging markets, or to some small- or mid-cap companies. Some investors see this as a good thing, offering greater "built-in" diversification. But if you want to more precisely control your international exposure, you'll want a clearer understanding of how your funds are invested. A Schwab representative can help you determine what's right for you.
1. Source: World Bank. Data for 2013. Market capitalization (also known as market value) is the share price times the number of shares outstanding. For listed domestic companies, which are the domestically incorporated companies listed on a country's stock exchanges at year-end. Does not include investment companies, mutual funds, or other collective investment vehicles. Data are in current U.S. dollars.
2. Source: World Bank. Data for 2013.
3. Source: World Federation of Exchanges. Data as of 12/31/13.
4. Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. In 2004, Austria was the best-performing developed market, up 72%; the U.S., as represented by the S&P 500 Index, rose 11%.
5. Source: MSCI. The foreign stock universe is represented by the MSCI All Country World Index ex USA; developed international markets are represented by the MSCI EAFE Index.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.
Investment value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.