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Getting better results abroad

Amy C. Arnott  |  16 Sep 2020Text size  Decrease  Increase  |  
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Investors looking to improve their portfolios' diversification by investing in stocks outside the US haven't had an easy time of it.

Non-US equity markets have lagged by a staggering margin over the past decade, with international market benchmarks falling behind their domestic counterparts by about 9 percentage points per year over the trailing 10 years through 31 August 2020.

That partly reflects the generally strong US dollar, but non-US stocks have fallen behind their stateside counterparts even before the effect of currency movements, partly because of weaker earnings growth.

Making matters more depressing, the returns international fund shareholders actually experienced after accounting for cash inflows and outflows have been even worse than reported total returns.

In our annual "Mind the Gap" study, which estimates the gap between investors' dollar-weighted returns and reported total returns, we found that in aggregate, the returns international fund investors earned for the most recent 10-year period ended 31 December 2019, continued to fall short of reported total returns by a fairly wide margin. This gap improved slightly compared with previous results, but still stood at about 1 percentage point per year, as shown in the chart below.

a chart showing Intl equity funds: 10 year return gaps over time

Bad Timing = Bad Results

Simply put, international investors have suffered because of poorly timed cash flows. More often than not, years when investors added more assets to international-equity funds have been followed by a downturn in total returns and vice versa, as shown in the chart below.

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a chart showing intl-equity asset flows and subsequent returns

The bar graph below shows the year-by-year results in more detail. The blue bars show each year's organic growth rate—the estimated net inflows or outflows for international-equity funds as a group, calculated as a percentage of starting assets for each year. The red bars show total returns for the following year. In nearly every case, the bars go in opposite directions, meaning that positive cash flows were followed by negative returns or vice versa.

A chart showing asset flows and subsequent returns

The past few years have been a good example of this pattern. In 2016, for example, net outflows totalled about 5 per cent of assets, but investors who sold missed out on significant gains in 2017. Small net inflows in 2017 were followed by painful losses in 2018. Outflows turned negative again in 2018, only to be followed by double-digit gains in 2019. In effect, international-equity investors have bought after big runups and sold after downturns—the opposite of the classic advice to buy low and sell high.


Improving your results

While investing outside the US has been challenging, there are a few ways to improve your odds of success. The suggestions below can help narrow the gap between reported total returns and the returns you actually experience.

Favour broadly diversified funds instead of betting on specific regions. Investors in highly specialized categories—such as funds focusing on Japan, Latin America, Europe, or China—have suffered the biggest investor return gaps, but those investing in broadly diversified categories—such as foreign large blend and world large stock—have fared significantly better. If you're trying to add international diversification, chances are you'll have far better results with a more mainstream offering. Betting on a specific region increases the odds that you'll be tempted to bail out at the wrong time.

A chart showing 10yr return gaps for international-fund categories

Look for lower-volatility funds. This tip is closely related to the one above, as highly specialized international funds also tend to have elevated levels of risk, as measured by standard deviation. In our study, we looked at the relationship between volatility and investor returns. We did this by ranking the funds in each category by standard deviation and then dividing them into quintiles. There wasn't a perfect relationship, but funds with the lowest volatility generally had narrower return gaps compared with higher-volatility offerings. For international-equity funds, funds in the least-volatile quintile had investor return gaps of negative 0.51 per cent, compared with negative 2.39 per cent for those in the most-volatile quintile.

Favour funds with more reasonable expenses. In our most recent Mind the Gap study, we didn't find a direct relationship between underlying fund expenses and investor returns. In other studies, though, we've found a fairly strong relationship between fund expenses and performance. In the semi-annual Morningstar Active/Passive Barometer study, for example, we found that success rates (defined as the percentage of funds that generated better returns compared with the average passively managed fund) were significantly stronger for funds with lower costs. Favouring low-cost funds won't necessarily improve your dollar-weighted returns, but it can help tilt the odds in your favour with respect to underlying fund performance.

Decide how much currency exposure you're comfortable with. Leaving your currency exposure unhedged can improve diversification because currencies don't always move in the same direction as each other or with their underlying equity markets. On the other hand, currency exposure adds another layer of risk. If you're extremely risk-averse, it may make sense to favour funds that hedge their currency exposure (although hedging won't improve returns if the US dollar continues to lose ground). Currency exposure won't directly impact your investor returns, but it's another factor to consider before venturing overseas.

Consider dollar-cost averaging. As part of our study, we looked at a hypothetical scenario in which an investor contributed equal monthly investments (dollar-cost averaging) to funds in each broad category group. For international-equity funds, we found that investors would have fared significantly better by investing a consistent amount month in and month out instead of piling in after periods of strong performance and bailing out after weaker years. In fact, dollar-cost averaging would have improved investor returns for international-equity funds by about 0.9 percentage points per year, on average, simply by helping shareholders avoid the adverse effects of bad timing.


Despite the challenges inherent in investing outside the US, non-US exposure is still a crucial component of a diversified portfolio. Domestic stocks have enjoyed a decade or more of outperformance, but that's not likely to continue forever. Valuations on US stocks have also been at a premium, suggesting there may be better opportunities overseas. In addition, the US dollar has already started weakening against other major currencies over the past few months. If the US dollar continues losing ground, that would provide a tailwind for international-equity funds with unhedged currency exposure.

That said, international-equity investing hasn't been easy even in the best of times. But following a more disciplined, consistent investment approach should lead to better results over time.


Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

See also Morningstar Guide to International Investing

is a portfolio strategist for Morningstar.

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