You'd hardly know it by looking at the dollars flooding into international mutual funds and ETFs, however. While assets often follow in the wake of strong performance, investors have been taking a rare contrarian tack with foreign stocks. Asset inflows into foreign-stock funds and ETFs have been robust for several years running, well before international equities began to rally.
Against this backdrop, a panel at the Morningstar ETF Conference in Chicago tackled some of the most crucial questions facing investors in foreign stocks--and to a lesser extent bonds--today. In a panel moderated by Alex Bryan, Morningstar's director of passive strategies research for North America, three investment strategists--State Street's Michael Arone, Vanguard's Fran Kinniry, and WisdomTree's Jeremy Schwartz--discussed optimal foreign-stock allocations, whether to hedge currency exposure, and whether foreign stocks are cheaper than U.S. today, among other topics.
How much of a portfolio belongs in foreign stocks?
Arone pointed out that most U.S. investors underweight foreign stocks relative to the global market capitalization, which is roughly 52% U.S./48% foreign today. Schwartz noted that in WisdomTree's internal benchmarks, it maintains roughly equal exposure to U.S. and foreign stocks. Yet Kinniry says Vanguard's target-date funds hold slightly smaller positions in non-U.S. names than appear in the global market cap.
"Up to a 40% weighting [as a percentage of equity exposure], adding foreign stocks reduces volatility," he said. "After that volatility increases."
What's the key benefit of international investing, anyway?
Vanguard founder Jack Bogle has provocatively said that investors don't need non-U.S. holdings, largely because so many large-cap U.S. businesses are globally diversified themselves. The panelists agreed on the global footprint enjoyed by many U.S. multinationals, but still believe that investors can derive a benefit from venturing overseas. Arone argued that investors shouldn't artificially limit their opportunity set to companies domiciled on U.S. shores; doing so represents a foregone opportunity for diversification and periodic outperformance, as in 2017. For Kinniry, a key argument for international equity diversification is a returns-smoothing effect: While the preceding 10 years have favored U.S. stocks at the expense of non-U.S., the 10-year period from 1997-2007 saw foreign stocks trouncing domestic names.
The panelists generally agreed that the performance patterns of U.S. and non-U.S. stocks are converging. But whether those higher correlations are here to stay is debatable.
"My view is that correlations aren't stable," Arone said.
Kinniry concurred, noting, "Correlations are rising, but they're still not at 1. You'll still smooth out returns to own both foreign and U.S. stocks, even with correlations at 0.8."[A correlation of 1 means that two assets move in the same direction.]
Should investors hedge their currency exposures when venturing overseas?
With the proliferation of hedged foreign-stock ETFs, obtaining exposure to foreign stocks without the currency swings has never been simpler or cheaper. But the panelists were mixed on whether to hedge or not to hedge. Schwartz, whose firm, WisdomTree, fields several hedged currency ETFs, made the point that U.S. large caps are sensitive--and growing more so-to the fluctuations of the U.S. dollar; appreciation in the dollar hurts U.S. businesses that are selling goods overseas. Hedging currency exposure provides an opportunity to reduce the U.S. dollar's impact on a foreign stock portfolio’s return.
"Leaving currency risk unhedged adds to a portfolio’s risk profile," Schwartz asserted.
Yet as his co-panelists were quick to point out, investors haven't always successfully timed their entry points into hedged international equity products, and investors may be tempted to engage in currency-timing trades with the hedged ETFs.
"You put assets into an ETF format and people trade them," Arone said, while Kinniry pointed out that the dollar-weighted returns in hedged equity products have been poor so far. Arone went on to argue that what really matters is consistency.
"Either hedge or don't hedge," he advised. "Don't try to time it."
Kinniry, meanwhile, noted that Vanguard doesn't hedge the currency exposure in the international-equity piece of its multiasset funds; equity holdings have numerous sources of volatility, including currency swings, but it's not disastrous given expected long holding periods. The firm does hedge the foreign-bond exposure in its multi-asset portfolios, however, because bonds are a lower-volatility asset.
Are foreign stocks cheap relative to the U.S.?
The panelists weighed in on the oft-cited argument that foreign stocks--especially emerging markets--are cheap relative to the U.S. Kinniry warned that investors need to be careful about their comparisons; one key point is that the sector composition of various markets is different; comparing, say, developed markets to emerging markets is a bit like comparing apples to oranges. Schwartz also noted that the sector composition of emerging markets, especially, has changed dramatically over time; markets that were dominated by commodities businesses in the past now have a healthy complement of technology names. That makes it problematic to compare the valuations of broad emerging markets indexes today with their historical valuations.
Caveats about benchmarking aside, Kinniry went on to say that "The U.S. market is no doubt overvalued."
Arone concurred, saying, "As an investor, you want to buy things that are inexpensive. Valuations are better and growth rates are better in Europe [than in the U.S.]."
For his part, Schwartz placed Japan as the cheapest major market today, followed by Europe, with the U.S. bringing up the rear.
Yet Kinniry also warned that investors shouldn't expect their foreign stock holdings to perform well if the U.S. market slumps.
"Hopefully no one is expecting that you will see strength in international if the U.S. market is down 20%-25%. In a market disruption, it's unlikely you will have a positive return [from your international equity portfolio], and you may even underperform the U.S."