Why Go Global?

2/4/2013


Ask investors why they own foreign stocks as well as U.S. stocks, and they're likely to cite one of two reasons:

• Foreign stocks boost returns.
• Foreign stocks diversify portfolios.

One of those reasons is true some of the time. The other is technically true but has little practical value.

Diversification

Adding foreign stocks to a portfolio containing the S&P 500 Index will diversify returns. However, the diversification benefit is minimal. In other words, if you're adding foreign stocks simply to reduce risk, don't bother.

Check out the table below. We created portfolios containing the S&P 500 Index, the MSCI Europe, Australasia, and Far East Index (EAFE), and the MSCI Emerging Markets Index (EM) in varying weights. Over the last decade, all of our portfolios generated returns more volatile than those of the S&P 500 alone. Over the last 20 years, portfolios containing 30% or 10% of the EAFE index were slightly less volatile than the S&P 500 alone. But they also delivered weaker returns. To measure volatility, we used standard deviation, which considers the spread of monthly returns around the average.

FOREIGN STOCKS DON'T DO MUCH ABOUT RISK
Below we present total returns for portfolios containing the S&P 500 Index (S&P), MSCI Europe, Australasia, and Far East Index (EAFE), and MSCI Emerging Markets Index (EM). We also provide a ratio measuring return per unit of risk, or annualized return divided by annualized standard deviation.
-------------------------------- Portfolio Weighting --------------------------------
70%
S&P,
30%
EAFE
90%
S&P,
10%
EAFE
70%
S&P,
30%
EM
90%
S&P,
10%
EM
70% S&P,
15% EAFE,
15% EM
100%
S&P
100%
EAFE
100%
EM
10-Year Annual.
Return (%)
7.7
7.3
10.2
8.2
8.9
7.1
8.7
16.9
Annual. Standard
Deviation (%)
15.5
15.0
16.8
15.3
16.1
14.8
18.4
24.1
Ratio
0.49
0.49
0.61
0.53
0.56
0.48
0.47
0.70
                 
20-Year Annual.
Return (%)
7.8
8.1
8.7
8.4
8.3
8.2
6.5
8.8
Annual. Standard
Deviation (%)
15.0
15.0
16.6
15.4
15.7
15.1
17.0
24.1
Ratio
0.52
0.54
0.53
0.54
0.53
0.54
0.38
0.37

Over the last decade, monthly returns for the EAFE index, which contains mostly stocks from developed countries, have been nearly as well correlated with the S&P 500 as has the S&P MidCap 400 Index. And in recent years, emerging markets have become increasingly correlated with U.S. and developed foreign markets.

Returns

Both the EAFE and EM indexes outperformed the S&P 500 over the last 10 years, but the EAFE lagged over the last 20. Foreign stocks can deliver superior returns; as the table shows, emerging markets have been particularly strong. But with that excess return comes volatility.

We calculated information ratios for the portfolios to measure returns per unit of risk. The higher the information ratio (annualized return divided by annualized standard deviation), the better. Most of our blended portfolios boast information ratios close to that of the S&P 500 alone, with some higher. Only you can determine whether the extra return potential is worth the extra risk.

Foreign options

Looking to add some foreign exposure? We recommend one foreign stock — Canadian auto-parts maker Magna International ($53; MGA) — and three mutual funds.

• Large-cap foreign: Manning & Napier International ($9; EXITX).
• Midcap foreign: Wasatch International Growth ($24; WAIGX).
• Emerging markets: Vanguard Emerging Markets Stock Index ($28; VEIEX).


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