International investing: active vs. passive

The active versus passive debate extends beyond the U.S. market to international investing as well.
Many advisors use the “core and explore” approach to investing such as using index funds for large cap U.S. stocks, but use an active approach in such areas as small cap U.S. and international investing. The argument for doing so suggests that international stocks are less efficient and active managers can better add value. After all, everyone is looking at stocks like Apple and ExxonMobil.
Proponents of active international investing might point to Morningstar data indicating that, over the past three years, the Vanguard Total International Index Fund (VGTSX) was bested by 66% of mutual funds. Despite low costs, it underperformed its category by 0.5% annually.
For those thinking this ends the debate, keep in mind that this same fund has bested 80% of international funds over a ten year period, and beat its category average by 1.24% annually.
Why has the international index fund been so easy to beat over the past ten years? Well, many, if not most, active international mutual funds also own some U.S. stocks. Over the past three years, international stocks significantly underperformed U.S. stocks. As of April 29, the MSCI EFA index total return (including dividends) gained 7.44% annually while the S&P 500 clocked in a 12.08% annual total return.
Thus, active funds received nearly a 5% annual boost from the portion of their portfolio that owns U.S. stocks.
My view is that William Sharpe’s arithmetic of active management applies every bit as much to international investing as to U.S. investing. Sharpe’s point is that before costs, the average international investor must equal the overall index, if properly measured. After costs, the average active investor must underperform the low cost index fund by the difference in costs. This arithmetic is not dependent on the efficient market hypothesis.
In fact, active international investing is far more expensive than in the United States. Research is more expensive and many international funds have staff in many countries. The larger expenses translate to a bigger differential in costs over an international index fund. That makes the arithmetic of active management even harder to overcome for international investing.