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Investing in International Mutual Funds: Is It Worth the Risk?

It's been a decade since international indices have returned much of anything

Have you looked at historical returns for international stocks lately? If so, you’d be justified in wondering if it makes sense to invest your hard-earned money in foreign equities now or in the near future.

Investing in International Mutual Funds: Is It Worth the Risk?

The last 10 years can be justifiably described as a lost decade for international stocks.

As measured by the MSCI EAFE Index, international stocks in developed countries have seen an annualized return of just 1.6% for the past 10 years.

Although smart investors know that past performance is no guarantee of future results, they also know that there is no guarantee that the next decade’s performance won’t be just as bad or even worse for international stocks than the past decade’s dismal performance.

Smart investors also know that investing in international stocks is not absolutely necessary for building a diversified portfolio. So the decision for investors to buy and hold international stocks now can be framed within a simple question: Are international stocks worth the added risk, especially if holding them is primarily for diversification purposes?

Should You Invest In International Stocks? Bogle Doesn’t Think So

In his book “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” John Bogle doubts the merits of foreign investing when compared to buying right here in the U.S.

Bogle says, “Here in a America we have … the greatest innovation, the most hospitable legal environment, and the finest capital markets on the globe.” Although Common Sense was published in 1999, Bogle has been mostly right since then.

Looking at the past decade and using mutual funds from the firm he founded, Vanguard Investments, the 10-year annualized return for Vanguard International Stock Index (VGTSX) is 1.6%, which compares to 6.9% for the Vanguard Total Stock Market (VTSMX). That’s a huge difference, to say the least.

Furthermore, when considering the added market risk inherent with international stocks, investing money overseas hasn’t been a good idea for the past 10 years. And when you’re talking about life savings in a long-term portfolio, that kind of differential turns into big money.

What does Bogle think about international investing today? He doesn’t appear to be changing his tune, compared to comments made in “Common Sense.” Just a little over a year ago, Bogle told Bloomberg, “I wouldn’t invest outside the U.S.” And when asked if he had ever invested in international stocks, he said, “Not really.”

How to Get the Most out of International Stocks

Advising investors to stay away from international stocks is an incredibly broad statement and possibly a mistake.

For example, the major market indices, such as the MSCI EAFE, are typically an average of several industrial sectors and are heavily weighted to large-cap stocks. But if you look at historical returns of international small- or mid-caps, or perhaps single out a few strong sectors, investors are smart to look all around the world for the best buys.

For a more specific example, consider an actively managed fund such as T. Rowe Price International Discovery Fund (PRIDX), which invests in small- and mid-cap international stocks. Its 10-year annualized return is 5%, which is much better than the MSCI EAFE and closer to that of domestic stocks. And if you go out further, to the 15-year return of 8.9% for PRIDX, you beat U.S. stocks, which was 5.5% during the period, as measured by  the S&P 500.

Not only are the returns of PRIDX strong, the fund can also provide greater diversification than that of an international stock index fund that invests in large-cap stocks.

Bottom Line on International Stocks

In summary, the big picture of international stocks over the past decade or so doesn’t look too pretty. And that’s the broad perspective of investors like Bogle, who prefer index investing.

Bogle’s advice to steer clear of international stocks may be wise when it comes to passive mutual funds and exchange-traded funds (which may continue to lag their domestic counterparts over the next decade), but this would be partially due to the fact that foreign markets have their inefficiencies; which is to say that indexing doesn’t work as well with international stocks as it does with large-cap domestic stocks.

A good stock picker can find compelling buys anywhere in the world and shouldn’t limit themselves to U.S. equities. For mutual fund investors, a well-managed international stock fund that ventures outside of the bounds of large-cap international indices can be a smart move, helping boost performance while adding diversity to their portfolio.

As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities. However he holds VTSMX for some client accounts. His No. 1 holding is his privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent a recommendation to buy or sell securities.

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