2 Favorite ETFs for Foreign Diversification

Karen Wallace: For Morningstar, I'm Karen Wallace. Should non-U.S. stocks have a place in investors' portfolios? Here to discuss the case for international diversification is Alex Bryan. He is director of passive strategies research for North America for Morningstar.

Alex, thanks so much for being here.

Alex Bryan: Thank you for having me.

Wallace: You recently wrote an article in Morningstar ETFInvestor about how international diversification can mitigate a portfolio's volatility and even enhance return. Some investors may say, I get plenty of global exposure through U.S. large-cap stocks. What would you say to counter that argument?

Bryan: Yeah. So, that's a great question. So, businesses have become increasingly global over the last few decades and it's true that most large-cap U.S. stocks do have a global presence. GE does as much business in the U.S. as they do outside the U.S., for example. And while that is true, keeping your investments confined to one market like the U.S. does limit the types of companies that are available to you.

So, for example, when InBev, which is a European brewer, bought Anheuser-Busch few years back, that took Anheuser-Busch out of most U.S. indexes. And so, if I am an investor who only wants to get exposure to U.S. stocks, that by definition limits the types of companies that I can invest in. And that's unfortunate because there's a lot of great companies, a lot of market leaders that are based outside the U.S.

So, if, let's say, InBev were to take market share away from Molson Coors or Toyota was to take market share away from GM, I wouldn't be able to diversify that risk. So, the global reach helps me get access to all the strong companies regardless of where they are located. It also allows me to better diversify local market risk that includes things like interest rate risk, political risk, valuation risk. U.S. stocks right now, even they have outperformed foreign stocks for the last decade or so, they are now trading at relatively rich multiples. So, if I focus on one market, I don't necessarily have the benefit of that global diversification. I don't get to be able to participate in the best-performing markets as I would if I were more broadly diversified.

Wallace: OK. International stocks have been more volatile than U.S. stocks. What's the source of that volatility and how can investors go global without meaningfully increasing their risk?

Bryan: That's a great question. So, most international stocks are more volatile principally because they are traded in foreign currencies. And that currency risk, when you invest in a European stock, for example, is the source of the added volatility. If you look at the volatility of European stocks, for example, in their local currencies, their volatility is actually comparable to U.S. stocks that are listed here.

So, if I'm an investor and I'm concerned about that risk, that extra volatility, I have one of two options. Either, one, I could invest in a currency-hedged stock fund that basically tries to mitigate some of those currency effects, in which case I may be able to bring the risk profile on to par with what I might have in the U.S.; or I could leave that currency risk unhedged but keep my allocation to foreign stocks at a more modest percentage of my overall portfolio.

Now, even though it is true that the unhedged stock returns of foreign stocks are more volatile than U.S stocks, because they are not perfectly correlated with U.S. stocks, if I combine foreign stocks with U.S. stocks in a portfolio, it may actually help slightly mitigate the overall volatility of that portfolio. But again, if you're going to leave the currency risk unhedged, it's best to leave that foreign exposure at a smaller percentage of your portfolio, if you are concerned about that overall volatility.

Wallace: How large an allocation to international stocks makes sense for most investors?

Bryan: A good starting point is, if you look at the composition of the global stock market, you will find that about half of the market is represented outside the U.S. and about half is in the U.S. Now, that's a pretty big allocation to non-U.S. stocks and there's a lot of good reasons why U.S. investors may not want to park so much of their equity portfolios in foreign stocks. For example, you do have the added currency risk, and a lot of U.S. investors may not be as familiar with non-U.S. stocks.

So, I did a bit of research on this to try to find what the optimal allocation would be if I was looking at reducing my overall portfolio volatility. And what I found was that using data from 1970 until March of 2017 a 33% allocation to non-U.S. stocks would have resulted in the maximum volatility reduction for the overall portfolio. Now, that maximum volatility reduction was pretty modest. It was about 5%. But still, there are some benefits beyond just that volatility reduction that you would get from going abroad. And like I said, 33%, it's less than half the market, so that's good. But I found that you can actually still get most of the volatility reduction benefits with even a smaller allocation than that. So, a 20% allocation to non-U.S. stocks would have given you about 84% of that maximum volatility reduction. So, it's a sizable chunk. But still, I think a 20% allocation for a lot of investors is pretty doable. It's not too scary.

Now, if I were to hedge out my currency risk, it would require a larger allocation to non-U.S. stocks to achieve the maximum volatility reduction. But the maximum volatility reduction is even greater there because I have reduced the volatility of that non-U.S. stock portion of the portfolio. So, I did some research on this as well and I found that about a 30% allocation to non-U.S. stocks with a currency-hedged portfolio would have given you about three fourths of the total volatility reduction that you could have achieved with a currency-hedged portfolio. So, I would say for most investors 20% to 35% is probably a nice sweet spot to be for your non-U.S. allocation.

Wallace: You make another point in your article that I thought was interesting and that's that an international allocation makes a lot of sense for investors who are outside of the U.S., that maybe their home country bias is limiting them even more than a U.S. investor would. Could you discuss that a little bit?

Bryan: Absolutely. So, the U.S. market is by far the most representative of the composition of the global market out there. Even though it's not perfectly representative, it represents, like I said, about half of the global market capitalization.

Now, if you look at the second biggest market out there, it's Japan, and Japan only represents about 8% of the world's global market capitalization. So, that's quite limiting. And if you think about the limitations of just focusing on that one market, it's quite substantial. There's a lot of sector biases with that market. There's also a lot of names within each sector that you're not able to own. So, if you look at it from the perspective of a Japanese investor, for example, Japan has had truly awful stock returns over the last 20 years or so. So, an investor in Japan, if they had a global portfolio, would have actually been able to obtain lower volatility even if they had a large allocation to non-Japanese stocks without hedging their currency exposure, and they would have been able to earn higher returns.

Now, I like looking at this from the perspective of a Japanese investor because it illustrates some of the dangers of focusing so narrowly on one market. There's nothing special about the U.S. market when it comes to the return profile of the market. While the U.S. stocks have done really well over the last decade, it could just as easily be the case that U.S. stocks could have underperformed the global market. So, I think this case illustrates the importance of being globally diversified so that you are able to participate in the best-performing markets regardless of where they are. You can't predict where they are going to be, but if you are globally diversified, it can make periods of underperformance in the U.S. market easier to bear.

Wallace: OK. And what are some highly-rated picks for getting exposure to international stocks?

Bryan: So, one of our favorite picks, just if you want to keep it simple, with a one-stop-shop for international stock exposure is the Vanguard Total International Stock ETF; the ticker is VXUS. This is fund that basically owns pretty much all major non-U.S. stocks, and it weights them according to market capitalization. So, it holds stocks across both foreign developed and foreign emerging markets. And this is a fund that we currently rate Silver. It has a very low expense ratio of 11 basis points and is representative of the composition of the global stock market. Now, it doesn't hedge its currency risk.

So, if you are concerned about currency exposure, I would suggest looking at a currency-hedged fund. Currency hedging, if you're going to do that, it's actually pretty cheap to do it in foreign developed markets. It's more expensive in foreign emerging markets. So, one of my favorite funds that I like for just foreign developed hedged equity exposure is the Deutsche X-trackers MSCI EAFE Hedged Equity ETF; the ticker is DBEF. It charges a 35-basis-points expense ratio. It basically invests in stocks that are listed in foreign developed markets overseas and then uses currency forwards to hedge out its currency risk. So, that way, you're able to mitigate some of the volatility associated with investing in foreign stocks.

Wallace: OK. Great. Thanks so much for sharing your research today, Alex.

Bryan: Thank you for having me.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.