One can excuse 401k investors and mutual fund owners for being confused over whether they should invest in foreign mutual funds or not. Arguments for and against global funds run the gamut. The argument used by folks like former Vanguard chairman Jack Bogle and his acolytes is that there’s little diversification benefit in foreign mutual funds since U.S. companies already derive a large share of revenues, and often an even larger share of earnings, from business conducted overseas. Also, the antis will tell you that you’re adding a new and unique risk to your portfolio when you invest in stocks that are denominated in non-dollar currencies.
I would counter that thinking by suggesting that companies based in foreign lands, with feet-on-the-ground expertise in their own markets, often have a distinct advantage over multinationals, particularly when it comes to more localized businesses. Yes, an oil company or a major drug producer may be able to sell its wares as easily overseas as it does in the U.S., but local cement makers, retailers and service providers probably have a good leg up on their foreign competitors. Like Google? Overseas, the company to watch is Baidu, and as an aside, Baillie Gifford — which runs chunks of Vanguard Global Equity (MUTF: VHGEX) and International Growth (MUTF: VWIGX) as well as a piece of Growth Equity (MUTF: VGEQX) — has a huge stake in the Chinese web giant, which happens to be the top holding at International Growth.
As for currency risk, it cuts both ways. Currencies can hurt, or they can help. With the dollar in a long decline over the past two years (but rebounding at the moment) investors in the U.S. got more bang for their buck by taking on currency risk.
Finally, there are those who’ll argue there are times to be heavily invested overseas, and other times when you should keep your money at home. Thanks. But market-timing is tough already, and trying to decide whether to focus here versus there is not as easy as the sound-biters would have you believe. Take a look at the chart below, which shows the relative performance of Vanguard Total Stock Market (MUTF: VTSMX)and Vanguard Total International (MUTF: VGTSX)since the foreign index fund’s inception. When the line in the chart is rising, U.S. stocks are outperforming foreign stocks (all based on U.S. dollar returns of course). When the line is falling, foreign stocks are tops. Clearly, there was a long pull favoring U.S. stocks from the mid-’90s to early 2002. That was followed by a long period of outperformance for foreign stocks until the middle of 2008. Obviously there were some reversals during the period, so how you were supposed to time those is beyond me.
Now look what’s happened over the past three years: U.S. stocks on top from Oct. 2007 to Oct. 2008, then foreign stocks winning through Oct. 2009 and U.S. stocks on top again through May 2010. Care to guess which way the pendulum will swing between now and December?
I don’t want to make a market-timing bet, and so my advice is the same as it’s always been: Buy foreign funds run by good managers and make an allocation in your portfolio that suits your risk temperament and long-term return aspirations.
Going Global
Why have this discussion at all? The emergence of a truly global economic village headlined the first decade of the 21st century, and the performance of foreign stock markets catalyzed investor interest. From Dec. 1999 through Dec. 2009, while the Vanguard 500 Index (MUTF: VFINX) lost a total of -9.8%, Total International gained 25.3%, and Vanguard Emerging Markets Index (MUTF: VEIEX) was up +155.3%! How can we not consider investing overseas? We now live in a world where many of the goods and services Americans want are produced outside of the United States (just check out our trade imbalance), and the rise of consumer classes in many emerging countries has boosted demand for those same goods and services.
Even though it’s easy to grasp the concept of a global economy, deciding on just how to put it to work in your investment portfolio is a more formidable task. Is it sufficient for a U.S. investor to allocate 10% or 20% of their stock portfolio to foreign companies? Do the big U.S. multinational firms owned by domestic stock fund managers provide enough foreign flavor to your portfolio given their global reach, as Jack Bogle would have you believe? And what about those currency fluctuations?
How about a more basic question: Is now a good time to be invested in foreign stock markets? You could have asked this a year ago or five years ago. My answer wouldn’t have changed: Yes, absolutely.
For decades, the U.S. economy was the engine of growth worldwide. U.S. consumers not only placed great demand on our own goods and services but also on those of foreign companies. Foreign consumers, as well, were eager to sample the fruits of the U.S. economic engine. Yet, as trade barriers have fallen and a new global consumer class has emerged, U.S.-based firms have ceded much of the new business in the world to foreign companies feeding this growing worldwide demand. The rise of a new middle class, with growing incomes and growing appetites for all manner of products, has led to a sharp rise in domestic demand in countries like the BRICs—Brazil, Russia, India and China—not to mention many still-emerging economies. China’s economy, now thought to be larger than Japan’s and second only to the U.S.’s, didn’t get there solely on the back of products made by and for U.S. companies. Local companies, and those with strong trade relationships and low costs of labor, are competing head-on with the giants of U.S. commerce and often winning sizable market share in their own homes, as well as in other non-U.S. markets.
Some of the biggest new consumer markets are the emerging markets, which have enjoyed extended economic growth and relative political stability. These countries are now creating a new consumer class of their own, and you and I are tapping directly into them through our holdings in International Growth, which currently allocates almost one-quarter of its portfolio to companies based in emerging countries. The American consumer and the American economy are both still a driving force in global demand, but we are now joined by many other consumers across the globe generating their own internal demand for more goods and services.
The creation of a new consumer class in many foreign countries creates enormous potential for U.S. investors. One of the most powerful investment themes in the years ahead will be identifying the companies, regardless of what country or part of the world they operate out of, whose goods and services will satisfy the demand of the emerging consumers in countries around the globe.
The fact is that much of the world’s economic growth already occurs outside of the United States. The International Monetary Fund (IMF) forecast released in July suggests that while the U.S. will grow 3.3% for all of 2010 and Europe will grow by just 1.0%, developing Asian nations will growth by 9.2%, with China and India expected to see growth at 10.5% and 9.4%, respectively. This more rapid growth means that faster-growing economies are grabbing a larger share of world production. If you have a U.S.-only portfolio, you are limiting yourself to investments in companies that produce slightly more than one-quarter of the world’s economic output. Moreover, the U.S. share of global economic growth is expected to continue to decline.
None of this is a death knell for the U.S. economy, or U.S.-based companies. The U.S. economy remains a vibrant growth engine. Moreover, the fact that America produces more than 25% of world GDP remains impressive when you factor in that we account for just 5% of the world’s population. But what is important to understand is that while the U.S. economy will continue to grow, it isn’t expected to keep pace with the growth rate of many other countries, especially those that are in the early stages of transitioning into modern industrialized economies. To gain exposure to the highest-growth opportunities in the world requires adding a sizable foreign stake to your existing U.S.-dominated investment portfolio.
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