Investing Overseas the Right Way

As I was researching a magazine story about foreign investing yesterday, I uncovered a stunning statistic. This is what I learned from the Investment Company Institute, which tracks the nation’s mutual fund flows:

After adjusting for withdrawals, 93 cents out of every $1 that investors sunk into stock mutual funds last year ended up overseas. And that’s not a typo.

Investors’ enthusiasm for foreign stocks isn’t surprising, but, in some respects, it is alarming. Americans’ excitement about international blue chips and emerging market pip-squeaks is understandable because the returns have been spectacular. Last year, MSCI EAFE, which is the popular foreign benchmark, generated a huge return of 23.08%. And that impressive performance was overshadowed by emerging markets, which soared 36.3%. What’s more, foreign investors have been rewarded by these supersized returns for several years.

So what’s the downside to all this? Most Americans, even retirees, should be investing overseas, but they should be doing it for the right reasons. Chasing performance is never a good idea, but I’m sure a lot of that new money is coming from fickle investors, who will pull their money out of Swiss chocolate, Japanese cars and Malaysian fertilizer plants as soon the foreign returns start to plummet.

There are two excellent reasons why you should add a dash of international picante to your portfolios. By doing so, you can potentially enhance your returns, while at the same time reduce the sort of harrowing, unpredictable market volatility that too often triggers investor stampedes into bank lobbies for the safety of CDs.

If you stick with a buy America investing approach, you’re betting all your chips on one roulette number. And often, you won’t fare as well as you might expect. To illustrate, here’s one example from the Schwab Center for Investment Research: From 1970 to 2005, the U.S. market failed to rank as the top performing developed market for even one year. This shouldn’t be surprising since there are dozens of other countries with stock markets. More than 37,000 companies are listed globally compared to roughly 5,000 corporations listed on U.S. exchanges. Many of the world’s alpha dogs are also living elsewhere. The world’s largest communication’s corporation is Nippon T&T in Japan and in the financial sector, Allianz of Germany is the top banana. In the utility universe, none of the top seven players are located here. By investing only in the U.S., you are leaving out essentially half of the world’s market value.

Just as importantly, investing overseas can also help temper your portfolio’s mercurial tendencies. Research from Charles Schwab, which is backed up by many similar studies, suggests that a portfolio that contains 75% domestic stocks and 25% international stocks will be significantly less volatile than one that sticks with American companies.

In another study, Vanguard researchers concluded that a 10% allocation of international stocks has historically reduced volatility of a domestic portfolio by 60 basis points (.6%) and the volatility drops 150 basis points (1.5%) if the allocation is 40%. In the study, Vanguard suggested that a starting international allocation for investors should be 20%, which is plenty for most folks.

What you don’t want to do is overdose on emerging markets. If you’re an aggressive investor, it’s probably best to devote no more than five percent of your equity exposure to these cherry bombs.

Foreign Picks

The best way to invest overseas is through mutual funds or exchange-traded funds. As with all your investments, you should pay close attention to costs. According to Lipper, the average annual expense ratio for foreign and emerging market funds is 1.63% and 1.91% respectively, which is ridiculously high. As usual, the cheapest ways to invest is through exchange-traded funds and index funds. If you prefer ETF’s, check out iShares MSCI EAFE Index Fund (EFA). PowerShares and WisdomTree also have a slew of international ETF’s.

For emerging markets, consider Vanguard Emerging Markets ETF (VWO), which has an expense ratio of .30%. Another emerging market play is iShares MSCI Emerging Markets Index Fund (EEM), but its expense ratio is higher at .75%.

Meanwhile, to get exposure to developing and emerging stocks simultaneously, consider a mutual fund, Vanguard Total International Stock Index Fund (VGTSX), with an expense ratio of just .31%. Or Vanguard FTSE All-World ex U.S. ETF (VEU).

If you want to learn more about foreign ETF investing, check out this story on MarketWatch about ETF competition.  Race to the bottom – Vanguard’s new international ETFs put fees in focus and pressure rivals

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