The benefits of investing in international stocks are clear. As shown in "On Top By Tens" chart below, during the 1970s and 1980s, the MSCI EAFE index dominated the performance of the S&P 500. A $10,000 investment in the MSCI EAFE on Jan. 1, 1970, was worth $169,631 by Dec. 31, 1989, compared with $89,172 in the S&P 500.
Since then, performance has changed. U.S. stock as measured by the S&P 500 outperformed the MSCI EAFE during the 1990s. During the most recent decade (2000-2009) the MSCI EAFE was slightly better than the S&P 500 (1.2% vs. -1%).
Although it lagged over the full 42-year period by 93 basis points, it's noteworthy that international stock produced an average three-year rolling return that was comparable to the S&P 500 (10.46% vs. 10.33%). Given the limited patience of most investors, international stocks deliver short-run performance that is similar to domestic stocks. Understandably, three years may not be a short-run period for impatient investors.
It's important to remember, however, that large-cap U.S. stock and international stock are simply two different ingredients in a diversified, multi-asset portfolio. The issue is not whether domestic stock is better than international stock or vice versa. Rather, the issue is determining their respective contributions to a diversified portfolio.
Toward that end, consider the performance data of 148 international stock funds from the Morningstar Principia database. This group of funds had to have a 10-year performance history as of Dec. 31, 2011, and be categorized as developed international stock (foreign large value, foreign large blend or foreign large growth). Morningstar categorizes the following countries as developed economies: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Singapore, Spain, Sweden, Switzerland and the United Kingdom. Let's filter out any funds that had more than 5% of their portfolio in bonds, U.S. equities or cash. Moreover, let's only include distinct funds, meaning that only one share class of a fund was included when funds are offered in multiple share classes. "The Big 25" chart below shows the largest 25 international stock funds by net assets.
PERFORMANCE IN A PORTFOLIO
The variation in 10-year performance among the 25 largest international stock funds has been sizable. For instance, Harbor International had a 10-year annualized return of 9.2% (as of Dec. 31, 2011) while Bernstein Tax-Managed International produced a 2.4% 10-year annualized return. Were these the only two fund choices in which to invest, the choice is quite clear based on historical performance. Of course, those two funds are not the only choices. In fact, there are hundreds and sometimes even thousands of choices when it comes to mutual funds and ETFs to invest in.
In order to do a fair, and manageable, comparison, this analysis assumed that each of the 25 largest international stock funds (one at a time) was inserted into a diversified 12-asset investment portfolio. The results were then measured over the 10-year period from Jan. 1, 2002, to Dec. 31, 2011. The 12-asset portfolio consisted of equally weighted allocations (8.33%) in the following asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, real estate, natural resources, commodities, U.S. bonds, TIPS, non-U.S. bonds and cash. The performance of each of the asset classes was represented by an established index - with the exception of non-U.S. equity, which used each of the 25 largest international stock funds.
The 10 annual returns of each international stock fund were inserted into the 12-asset model - one fund at a time - and the 10-year performance of the entire portfolio was calculated (see "Portfolio Performance" chart below). Despite large performance differences among the individual international stock funds, the 10-year annualized return of a 12-asset portfolio was largely unaffected by which international stock fund was utilized.
For example, when the 12-asset portfolio utilized Harbor International, the 10-year return of the 12-asset portfolio was 9.32%. If Bernstein Tax-Managed International was used in the 12-asset model the resulting 10-year average annualized return was 8.76% - a difference of only 56 basis points despite an enormous difference in the 10-year returns of those two specific international stock funds.
This illustrates a vitally important point: the asset allocation model is more important than the individual fund being used in the model. As shown, there are a number of perfectly adequate international stock funds in terms of performance. What matters is building a broadly diversified portfolio rather than getting hung up on picking the "perfect" fund in any particular asset category.
Craig Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio with a Plan.