Let’s say you’ve decided your portfolio would benefit from some type of international diversification. After all, with roughly half the world’s market capitalization residing outside the U.S., there must be opportunity somewhere.
But how should you choose your international investments?
Many people instinctively look for stocks, bonds, mutual funds or exchange-traded funds that have been performing well. Taking that approach, investors would undoubtedly notice returns from India, the Philippines and Thailand, which are showing strength in early 2015.
Investors may believe a particular country or region is ready to zoom higher, and they want to get on board early. Still, others take the position that a portfolio should be fully diversified at all times, and investors should not cherry-pick countries or regions.
Professional money managers often recommend broad international diversification as opposed to do-it-yourself stock picking.
Jeff Papp, principal at Oberweis Asset Management in Lisle, Illinois, says investors should have exposure to areas of the world where stocks appear likely to rally in the foreseeable future.
However, as assistant portfolio manager of the Oberweis International Opportunities Fund, Papp says it’s a delicate balance between owning the current crop of top performers alongside stocks that have underperformed. He notes that U.S. stocks outpaced other developed economies in 2014. He says investors should continue owning U.S. stocks, but also position themselves to get returns from the developed European nations, which he believes will rebound this year from their 2014 slump. So far this year, many developed-Europe funds are beginning to show signs of life.
As a growth catalyst, Papp cites the European Central Bank’s asset purchase program that begins this month and is set to run through September 2016, if not longer. In the U.S. and U.K., such central bank programs boosted economic activity, which, in turn, lifted equity markets. Papp expects the same to happen in the eurozone.
“We feel eurozone equities are priced as if no economic activity is going to occur. If we do get some economic activity, helped by the ECB announcement about their asset-buying program, that makes for an interesting situation,” he says.
Papp emphasizes that investors should hold European stocks alongside those of other developed nations, such as Canada, Japan and Australia, as well as emerging markets.
John De Clue, chief investment officer at U.S. Bank’s Private Client Reserve in Minneapolis, says investors should have an understanding about which regions are likely to grow and which may lag.
“Look very closely at the emerging middle class overseas. There are fascinating stories in countries like the Philippines and Vietnam that deserve attention. And you can even argue that if Ukraine settles down, there are some Eastern European situations that could be very interesting,” he says.
“Avoid the oil-dependent economies for for now, and probably for the next couple of years, based on our view of the outlook for oil,” he adds.
DeClue, who uses both active and passive management styles in client accounts, says investors should consider paying an active manager to identify and research opportunities throughout the world.
On the indexing side, he advises investors to be aware of what they are buying, and not make assumptions based on a product’s name or stated objective. He cites the Morgan Stanley Capital International Emerging Markets index, which is tracked by the popular iShares MSCI Emerging Markets ETF. DeClue says the index is currently weighted down by two troubled economies: Russia and Brazil.
It also includes two countries De Clue sees as developed economies: Taiwan and South Korea. Investors hoping to get returns commensurate with a strict interpretation of emerging markets may be disappointed.
“An investor who is able to withstand more volatility and trying to be a little more on the cutting edge may not realize they are investing heavily in two countries which are very developed,” De Clue says.
Other advisors believe investors are better off avoiding predictions about countries or regions.
“Stay away from betting on individual countries,” says Eric Nelson, co-founder and CEO of Servo Wealth Management in Oklahoma City. He maintains that the performance record of a country’s stocks does not indicate how they will do going forward.
“No matter how poorly they have performed or how well they have performed, it really doesn’t say a lot for the near-term future. Look at Japan: Fifteen years ago, it had already underperformed for a decade, and it’s continued to do so for the past 10 or 15 years,” Nelson says.
Stephen Stricklin, founder of Wise Wealth in Lee’s Summit, Missouri, has a similar investment philosophy. He notes that a diversified portfolio, regularly rebalanced, gives investors the opportunity to buy international stocks at value prices, without trying to time their buys, pick stocks or chase performance.
“There’s no pattern to the best-performing asset classes. You can’t determine which one is going to be the best one next year. Some years it’s international, some years it’s the U.S. Sometimes it’s small companies. Sometimes it’s large. The key is to own every one of them. If you have a truly diversified portfolio, you’ll probably own the worst-performing asset class in any given year, and also the best one,” Stricklin says.
He points to a 2014 study by financial services researcher Dalbar, which shows individual investors’ returns tend to be lower than the wider market.
“The average investor underperforms the market every year by a wide margin, because they are trying to beat the market with stock picking, market timing and track-record investing,” he says. Nelson also says investors put themselves at unnecessary risk by making bets on specific countries or regions.
“If you try to gain diversification, but you concentrate in a particular area you think looks more attractive than other areas, you could easily wind up being wrong. So the diversification idea made sense. You just didn’t deploy it right,” Nelson says.
He suggests using a small number of index funds that encompass various global regions. “Don’t concentrate on one particular country or section of the world. You don’t know who the next Japan will be or who next high-growth country will be,” he says.
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