Many investors are diversifying their portfolios with international stock funds. Their goal is to increase returns and reduce risk by investing in assets that are not directly correlated to their domestic stock funds. What are international stock funds and how can they benefit your portfolio?
How do these funds work?
International stock funds invest in the equity of non-US corporations. We are all familiar with the names of large international corporations such as Toyota, Samsung, Bayer, and Nestle but rarely are we able to invest in these corporations through our domestically focused stock funds. The international stock funds give you the opportunity to put your money into these non-US based companies.
The funds are benchmarked against an index of publically traded companies. In the PERA 401(k) plan, the PERAdvantage International Stock Plan is benchmarked against the Morgan Stanley Capital International All Country World Index Excluding US Companies. This is a market capitalization weighted index which means that the exposure to each company in the fund is weighted by the company’s size as measured by its market capitalization. The biggest companies have the greatest exposure. The four biggest companies in this index are Nestle, Novartis, Roche, and Toyota. Measured by their home country the index is most heavily weighted in Europe, then Asia and then the Americas.
Since these companies are domiciled outside of the US, their assets are valued in their home currencies. Purchasing shares in these companies gets you non-dollar exposure. In addition to the gains or losses in their share value, you get the extra dimension of currency exposure. This can enhance or detract from the investment performance giving you a boost when the dollar is falling and penalizing you when the dollar is rising.
Why is this important to me?
Investing in international funds increases diversification and reduces the risk in your portfolio. The international companies are working in economies that may be on a different growth path and business cycle than domestic companies. To the extent that these companies are not correlated with domestic US companies, they can smooth out the hills and valleys of price fluctuations in your portfolio. Also, with exposure to foreign currencies you have a new currency leaver to smooth returns.
What are the pros and cons?
The largest benefit is having an asset that in not correlated with the rest of your investments so that it can smooth out the bumps in your portfolio value. If your domestic funds are going down and the international component is going up, then your total portfolio value will be more stable. This works up to a point and that is dependent upon how much you have invested in international funds. Remember at the end of the day you will want to spend your savings in US dollars, so a large international exposure could hurt you if it under-performs your domestic funds. For that reason advisors usually recommend only a 15% weighting towards international funds. Another consideration is the fees in international funds are usually higher. In the PERAPlus plan the international fund fees are 0.59% versus 0.35% for the U.S. Large Cap Stock fund. That may seem like a small increment, but it is a 68% higher fee and this can take a bite out of your final wealth over the long run.
Is this the right time to be buying international funds?
Over the past year the U.S. dollar has appreciated over 25% versus a basket of foreign currencies. This means that the dollar will buy 25% more than it would have a year ago. While your friends may be planning a trip overseas because their dollars will buy more, perhaps you should be considering investing overseas for the same reason. The foreign stocks have gone up in price in their domestic markets, but with a stronger U.S. dollar, you have a relative advantage. If in the future the currency reverses and the dollar trades lower, you will benefit from the currency gain. Buying into international funds works to your advantage when the dollar is strong.
Diversifying your portfolio investments with international stock funds reduces the risk in your portfolio to the extent the returns are uncorrelated. This can smooth put the ups and downs of your stock portfolio values. If you are the type of investor who worries when the total value of your portfolio goes up or down, them maybe you should consider adding a small amount of diversification with the international funds.