Three Reasons to Consider Investing in International Equities

September 28, 2020

Three Reasons to Consider Investing in International Equities

09/28/2020

Greg Liebl


Greg Liebl, CFA

Senior Investment Strategist

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The historic US bull market run reinforced investors’ home-country bias. But this bias may be hurting your returns and increasing your portfolio’s volatility.

When it comes to investing in the stock market, we tend to hold a large allocation to our country of residence. This home-country bias means many US investors load up on US stocks and hesitate to invest in international equities. But if investors take a longer-term view, they might see that this emphasis on a single country isn’t optimal. Failing to look across borders at shares of non-US companies means you’re overlooking complementary assets—securities that may zig when the US zags.


Here are three reasons why a preference for buying local may put your portfolio at a disadvantage.


US equities won’t outperform forever

If this first reason sounds familiar, that’s because it is. Investment strategists issued this warning repeatedly throughout the US market’s 11-year bull run. These warnings were meant to remind investors that the historic bull market would end at some point—which it abruptly did in March—and they should consider what that would mean for their portfolio.   


Consistent outperformance from US equity markets isn’t the natural state of affairs. As shown below, stock market leadership has alternated between US and international equities numerous times over the past four-plus decades. There have been lengthy periods of both outperformance and underperformance of US stocks relative to international stocks (international refers to developed markets outside the US, typically taken to be those countries represented by the MSCI EAFE Index).

 

Annualized three-year excess return of the MSCI USA Index vs. the MSCI EAFE Index (gross TRs), rolling monthly

Three Reasons to Consider Investing in International Equities

Sources: MSCI, Bloomberg, Parametric, 6/30/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index. Past performance is not indicative of future results. All investments are subject to the risk of loss.


The chart above shows distinct periods of international dominance, including a phase in the 1980s when Japan’s bull market crushed that of all other countries, and another in the early 2000s after a string of accounting scandals rocked the US. Excluding international equities precludes your portfolio from taking advantage of these periods of international outperformance.

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International equities are a valuable source of diversification

International stocks can act as an important source of diversification, improving a total portfolio’s expected risk-return profile versus a portfolio that includes only US equities. This benefit comes from holding securities in a variety of countries, each reacting differently to market and economic conditions. 


Investors can increase diversification by holding securities denominated in various currencies, each of which behaves somewhat independently of the underlying stock price. Different markets and currencies tend to respond to market cycles and world events in their own unique ways, experiencing downturns and upturns at varying times and magnitudes from the US.


By tapping into these offsetting patterns, investors may reduce overall portfolio volatility, providing a smoother ride with similar returns compared with investing in US stocks alone. We can see the diversifying power of international equities in the table below, where we show the average three-year return for an index of US equities compared with a blend of indexes that allocates two-thirds to the US and one-third to stocks outside of the US, rebalancing on a monthly basis. Over the prior 40 years, the average three-year return between the single index and the blend is practically indistinguishable. However, by investing non-US stocks, an investor could have reduced average volatility by a meaningful margin.


Average annualized three-year return and volatility for US and US/international indexes, 12/31/1972–6/30/2020, rolling monthly

Three Reasons to Consider Investing in International Equities

Sources: MSCI, Bloomberg, Parametric, 6/30/2020. Index performance is provided for illustrative purposes. It is not possible to invest directly in an index. Indexes are unmanaged and do not reflect the experience of any investor. Index performance does not reflect the deduction of management fees and transaction costs which would reduce the returns presented. Index performance is not intended to reflect the performance of any strategy offered by Parametric. Past performance is not indicative of future results.


International equities are too big to ignore

When home-country bias leads US investors to favor US stocks heavily, it cuts them off from a significant part of the global investment universe. The MSCI ACWI Index’s allocation to non-US developed countries is 30%. This means that if a portfolio holds only US stocks, it essentially ignores about a third of the opportunity set—nearly half if one considers all non-US markets, developed and emerging.


MSCI ACWI geographic weights 

Three Reasons to Consider Investing in International Equities

Sources: MSCI, FactSet, 6/30/2020. For illustrative purposes only. It is not possible to invest directly in an index. All investments are subject to the risk of loss.


The bottom line

Home-country bias and the pull to buy local is real, and it only grew stronger during the historic US bull market run over the past decade. But this bias leaves US investors vulnerable to an extended period of US equity underperformance, and it could have a lasting negative impact on portfolios. Investing in international equities allows investors to take advantage of the potential periods of international outperformance while gaining the benefits of diversification at the portfolio level. At a minimum the result may be a portfolio with a similar expected return paired with lower expected volatility than a purely homegrown US equity portfolio.


For a fuller perspective on investing in international equities, download our whitepaper.

Global market investing (including developed, emerging, and frontier markets) carries additional risks or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Future investments may be made under different economic conditions, in different securities, and using different investment strategies. 

The MSCI USA Gross Total Return Index is designed to measure the performance of the large-cap and midcap segments of the US market. With 616 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US. The MSCI EAFE Gross Total Return Index is an equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the US and Canada. With 902 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI All Country World Index (ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. "MSCI” and MSCI Index names are service marks of MSCI Inc. (“MSCI”) or its affiliates. The strategy is not sponsored, guaranteed or endorsed by MSCI or its affiliates. MSCI makes no warranty or bears any liability as to the results to be obtained by any person or any entity from the use of any such MSCI Index or any data included therein.



 

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.

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