The total U.S. stock market has gained over 20% during the past year and is doing great. But for U.S. investors that are under-weighted to foreign stocks, it’s not so great. Why? Because foreign stocks have convincingly outperformed U.S. equities, thereby causing a performance deficit. What’s the problem?
The tendency of investors to concentrate and tilt their stock and bond holdings toward their home country is referred to as “home-bias investing.” And strong returns in the U.S. stock market (DIA) have largely camouflaged the problem of being over-weighted to domestic stocks.
Emerging market equities (VWO) from countries like China, India, and Brazil have gained almost 29% during the past year, while developed market stocks (EFA) are ahead by almost 27%. In each case, it’s meant a performance advantage to investors smart enough to diversify their equity exposure globally.
Perspectives on Growth and Size
From a growth perspective, many emerging market countries are tiny and still have upside potential.
For example, Apple’s $878 billion market cap exceeds the stock market capitalization in emerging countries like Indonesia, Mexico (MEXX), and Turkey (TUR). The rationale for diversifying into foreign markets boils down to obtaining exposure to financial markets that are influenced by a variety of forces beyond the U.S. economy and its politics.
Foreign stock and bond index ETFs offer investors broad global diversification at a cost that’s often 90% or more less expensive compared to actively managed mutual funds and hedge funds investing in the same category.
Hidden Benefits
Beyond securities diversification, foreign stock and bond ETFs offer another little-mentioned advantage: currency diversification. How does it work?
Since foreign securities (stocks and bonds) are denominated in their local currency, this allows investors who own a foreign index ETF some currency exposure away from their local currency, like the U.S. dollar for U.S. based investors. This advantage is most noticeable when the U.S. dollar is weak relative for foreign currencies. And when this phenomenon occurs, it can add performance gains on top of gains in securities.
