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 (NYSEARCA:DIA) hves largely camouflaged the problem of being over-weighted to domestic stocks.
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Emerging market equities (NYSEARCA:VWO) from countries like China, India, and Brazil have gained almost 29% during the past year, while developed market stocks (NYSEARCA: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 (NYSEARCA:MEXX), and Turkey (NYSEARCA: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.
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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.
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.
Overcoming Biases and Excuses
The most difficult aspect for overcoming home-bias investing is not technical but rather behavioral.
For instance, certain investors deliberately load up on U.S. domiciled multi-national stocks like Amazon.com, McDonald’s, or Johnson & Johnson. The logic is that since these firms generate a significant portion of their revenues globally, the diversification benefits of foreign stocks is already reflected in the price and performance of these mega-cap U.S. based companies.
While we certainly cannot ignore the trend of globalization, investors that deliberately omit foreign stocks are guaranteed to miss exposure to world-class foreign companies like Alibaba Group, Novartis, Tencent Holdings, and many others.
And then there’s the issue of currency diversification, which we discussed earlier. Because many large multi-national firms hedge away currency exposure to their foreign operations, this secondary but important diversification benefit is wiped out. By investing in foreign stocks you overcome this disadvantage by getting pure un-hedged currency exposure which you will appreciate after the U.S. dollar or your local currency begins to weaken.
The barriers of cross-border investing have been completely torn down and destroyed. And thanks to low cost index ETFs, the cost of investing in foreign markets has never been more affordable or efficient. Don’t let home-bias investing cause you to miss out on the performance action elsewhere around the globe!