The Role of Foreign Investments
Over the last five years foreign equity markets have significantly outperformed the U.S. market, causing the subject of foreign investing to be very popular with both investment professionals as well as the general public.
Truepoint has always maintained a healthy allocation to foreign equities for the primary purpose of reducing portfolio volatility through additional diversification. In light of recent performance, many individual investors are now revisiting their foreign equity exposure with the thought of increasing portfolio allocations. This consideration necessitates answering two questions: Does it make sense to increase the foreign equity exposure in your portfolio? And is now the right time to make a change?
A quick examination of the historical returns for foreign large-cap stocks shows them to be largely indistinguishable from those of U.S. large-cap stocks. In fact, in dollar denominated terms, the returns are less than 0.1% apart between the years 1970 and 2005. When measured in local currencies over the same time period, the foreign equity markets lag the U.S. markets. This begs the question of how much of the recent strong performance in the foreign equity markets is due to the weak dollar. It also begs the question of whether the foreign equity markets can continue to outperform the U.S. markets if the dollar stabilizes against other currencies.
While currency has clearly played a role in the strength of the foreign markets, so has the growth of many of these markets. Emerging market countries such as India and China are experiencing strong economic growth as they increasingly supply products and labor to many developed nations. However, while these developing countries are likely to continue to grow at a much faster rate than the U.S., this does not necessarily mean that developing market stocks will perform better than U.S. stocks. Growth should not be confused with investor return; growth provides superior investment returns only when a reasonable price is paid for growth.
It is also important to remember that returns from the emerging market asset class, which has recently performed exceptionally well, should be higher than both foreign developed markets and the U.S. market since these markets carry a significantly higher level of risk. Consider the performance of an investment in the stock index of the Philippines during the Southeast Asian financial crisis: a $100 investment at the beginning of 1997 was worth only $13 by the end of 2002.
Returns, however, are not the only factor to consider. Even with similar average returns, foreign equities should be a part of a portfolio if the addition of the asset class increases portfolio diversification (thereby reducing volatility). Unfortunately, given the trend of globalization, recent evidence suggests that large-cap foreign equities are more correlated with large-cap U.S. equities than ever before. The average correlation (a measure of the degree of relationship between two variables) of .50 that investors enjoyed in earlier decades has increased to .80 in the past 10 years as markets have become increasingly global. However, there are other areas of foreign investment that can bring an added level of diversification with lower correlation to the U.S. markets. For example, international small-cap and value stocks both offer a greater level of diversification benefit.
As foreign market capitalizations continue to expand over time, it does make sense to reflect that increase in portfolio allocations. However, implementing this increase in an opportunistic and focused manner is critical to maximizing portfolio benefit. So while we are likely to grow our foreign exposure over time, we will remain disciplined to our philosophy by doing so during periods of weakness within foreign asset classes. When presented with attractive buying opportunities, foreign allocations will be advanced in those areas of the market offering the greatest opportunity for additional portfolio diversification. Rest assured that any permanent increase in the portfolio weight to the foreign equity asset class will be a function of a strategic opportunity as opposed to chasing recent price performance.