While foreign stocks are often an afterthought during a bull market, the sting of steep declines among U.S. stocks serves as a reminder that investors shouldn’t put all their eggs in one basket, notes Rich Moroney, editor of Dow Theory Forecasts.
To be sure, with foreign stocks struggling, making the case for them may seem silly. The popular FTSE All-World Ex-U.S. Index, which invests in nearly 50 developed and emerging countries outside the U.S., is off 15.5% so far in 2022, compared to a decline of 13.3% for the S&P 1500 Index.
That said, provided you recognize the benefits of diversification and focus on long-term growth, adding an international fund or two to a mostly U.S.-stock portfolio makes sense. For the record, foreign stocks can limit risk, not remove it. Still, spreading your bets across the globe can result in a less-volatile portfolio.
Moreover, investors can find faster economic growth in foreign markets. The International Monetary Fund (IMF) estimates that all major international regions will increase GDP faster than the U.S. both this year and next year. In 2022, Asia’s massive developing and emerging markets are expected to grow 4.6%.
Europe’s markets are forecast to grow 2.6%, with Latin America up 3.0%. In contrast, the U.S. economy is projected to grow only 2.3% this year.
Global economic growth is notoriously difficult to predict. Most projections are tumbling, hurt by rising energy and fuel prices, supply chain disruptions, and the war in Ukraine.
The IMF now sees world economic growth slowing to 3.2% this year, versus a 6.1% increase in 2021. The IMF has repeatedly cut its forecast for 2022. Blame the slowing growth projections on rampant inflation in many economies, causing central banks to raise interest rates.
Case in point: To combat inflation running at a 40-year high, last month the U.S. Federal Reserve raised its benchmark federal-funds rate to a range between 2.25% and 2.50%. The key rate is expected to climb to around 3.5% by year end. The European central bank, most banks in Asia, and the Bank of England have raised rates.
Complicating matters, a strong U.S. dollar is pressuring many central banks, particularly in emerging economies, to raise interest rates even at the risk of a recession. A weak currency can stoke inflation, begetting even more price hikes. The WSJ Dollar Index, which measures the dollar against a basket of 16 currencies, is up 10% since the start of the year.
Our advice
Unless you’re willing to research foreign stocks on an individual company basis, investors are typically better off owning a mutual fund or exchange-traded fund. Foreign stock funds have long been a core holding in our recommended fund portfolios. Today, they represent nearly 11% of the Conservative Portfolio and about 14% of the Growth Portfolio.
When evaluating a fund, determine if it uses currency hedging. When the dollar rises against foreign currencies, a hedged fund will have an edge. When the dollar declines, unhedged funds tend to outperform.
iShares MSCI Int’l Small-Cap Multifactor (ISCF) joined our recommended funds in June because of its solid track record and strong fund score. The ETF holds nearly 690 small-cap and midcap stocks diversified across more than a dozen countries, including Japan (25% of market value), Canada (15%), and the U.K. (15%).
The diverse portfolio spans such attractive sectors as industrials (22%), consumer discretionary (12%), and technology (10%). The portfolio, which doesn’t hedge currency, has a value tilt.
iShares MSCI Int’l Small-Cap has outpaced the average small/midcap foreign fund in four of the last five years. The fund has a five-year annualized return of 3.4%, ranking it among the top 5% of its peer group. Today, it boasts a fund score of 89 and earns a five-star rating at Morningstar.
A longtime component of our recommended portfolios, Vanguard International Growth (VWIGX) underperformed in 2021 and is trailing again this year. But the unhedged mutual fund ranked among the top one-third of large-cap growth funds for five consecutive years starting in 2016. It boasts a 10-year annualized return of 9.7%, ranking it among the top 6% of its category.
Holding nearly 120 stocks, the fund is around 50% invested in Europe, with 22% of assets in emerging markets. The largest country exposure is China at 16%, while its biggest holding is a 5% position in ASML Holdings (ASML), a Dutch supplier of semiconductor equipment. The annual expense ratio is 0.43%, below the category average of 0.94%.
