Investing in foreign shares may reduce the risk in your stock portfolio.

The level of global economic and geopolitical turbulence in recent years has led to questions about what the right mix of international exposure is. A related question is whether you should own any foreign shares. In this article, we discuss the role of international exposure in your investments and how diversification into international investments can help you achieve your investment goals. We will also answer some of the common questions we have received.

A global perspective on diversification: the long-term benefits

Swedish shares are of course most vulnerable to the tight economic forces in the Swedish market, just as US shares are most vulnerable to what happens in the US market. In contrast, foreign stocks can provide exposure to a wider range of economic and market forces across regions and nations. Different markets and economies can and often do provide returns that vary from the US market.

The table below shows industrial sectors in Sweden together with, among other things, market capitalization and number of shares. Some sectors are not represented at all on the Swedish stock market, such as oil companies, so buying foreign shares is necessary to gain this exposure.

Over time, the diversification of returns from exposure to international investments can benefit investors. In any market environment, diversifying investments across domestic and international opportunities can position your portfolio to take advantage of the region(s) that are performing well at a given time and help offset areas that may be underperforming.

Why does exposure to international stocks still make sense in the current economic environment?

This is a good question. The explanation starts by defining the term we’ve been hearing a lot of lately in the press – de-globalization.

“In very general terms, ‘de-globalization’ is the decoupling, or reduction of interdependence and integration between the world’s economies. This is the opposite of a globalization trend since the end of World War II, a trend that has accelerated in the last 30 years. A good example of de-globalization would be the push in the US to use domestic oil and gas sources instead of depending on foreign nations for energy needs. Another would be Swedish companies buying lightly manufactured goods in Skövde instead of abroad.

There are both advantages and disadvantages to de-globalization. As countries de-globalize, they build up their internal capacity and their business grows. They become self-sufficient and move away from dependence on other countries. The upside is that in the longer term it could mean more diversification of producers, improved price competition and greater economic independence from country to country. What this means is that when the US economy is down, some international economies can be up and vice versa. This diversification can be good for your portfolio in the long term.

The downside is that de-globalization can create uncertainty as investors adjust to a shift away from global dependence between nations’ economies. This puts pressure on international stocks as companies deal with supply chain and labor issues, many exacerbated by the pandemic. The dramatic changes in the market, especially in the last two years, have created a misconception that de-globalization has already occurred. The reality is that such a significant transformation does not happen overnight, or even over a few years. It is a long-term process whose results will take a long time to play out, just as globalization took many years.

We also need to make sure we know what we mean when we say ‘international’. There are developed international markets such as Germany, England and France. These markets represent 71% of non-US stocks and have advanced economies, developed infrastructure and a higher standard of living. The second group of non-US stocks comes from emerging markets, sometimes referred to as emerging markets such as China, India or Brazil. Many emerging markets have less developed markets, less advanced economies and infrastructure and a lower standard of living. They also tend to have higher volatility, a younger population and rapid economic growth.

Investing in foreign shares – challenges and opportunities

The short-term outlook for international investment faces some headwinds.

Challenges for the EU energy complex. The Russia/Ukraine conflict has disrupted energy production. Any rationing of energy use, voluntary or involuntary, can have a negative impact on production, real activity and growth for the region. This could cause energy shortages/rationing in the coming winter season, further challenging Europe’s economic outlook.

Continued strength in the US dollar – A strong dollar is a mixed blessing. A strong dollar means it is cheaper for American consumers to buy imported goods and for American tourists traveling abroad. But it also means that it is more expensive for foreign consumers and businesses to buy American goods, and that hurts American businesses.

For the more economically sensitive E.U. and emerging markets, this means that American goods are more expensive. When investing internationally, US dollars are converted into local currency – and vice versa when an investment is sold. These exchanges can affect the value and ultimately the return on an investment. Until mid-year 2022, the strength of the dollar has been a significant headwind for the performance of non-US stocks. Another country that is having trouble with its strong currency is Switzerland, whose currency has just tested its all-time high level against a number of other countries’ currencies.

Interest rates in Europe – The European Central Bank (ECB) has just started its interest rate hiking cycle, which could further slow down European economic growth. This is important because European markets, collectively, are as large as the US market and represent a large share of non-US stocks.

Slowing global consumer demand will weigh on emerging markets and China. In mid-July 2022, inflation was around 9% in the US. Inflation will remain high in Latin America this year – from a forecast of almost 8% in Brazil to 4.5% in Peru. The same applies to Eastern Europe, where inflation has peaked at 22%. Emerging markets in Asia, such as Thailand, where inflation stands at 6.2%, are likely to see more policy tightening. As inflation has heated up, demand has slowed down for many non-essential goods, such as holidays and large household appliances.

The pandemic became an accelerator of de-globalization. During the pandemic when China was shut down, semiconductors were not available in the US. This made new cars more difficult to manufacture, driving up the prices of new and used cars. This is a good example of the downside of globalization.

China is expected to recover, but only moderately. China’s ‘zero covid’ policy delayed economic recovery there, adding to supply chain concerns, even as much of the rest of the world reopened. The longer it takes for China to return to normal, the longer it takes for the rest of the world to recover.

On the surface, these factors seem to paint a challenging picture. However, there are opportunities to invest in international stocks, and many reasons why exposure to international stocks still makes sense as a long-term strategy. While investors are experiencing challenges today, the long-term perspective is important to keep in mind.

The opportunity to benefit from international exposure

Historically, the US stock market has not always been the best. In fact, this stock market has only been the best for four years since 1988. It is the same for Switzerland, and lower than Austria, which has actually had a very good development on several occasions. The likelihood that you have Austrian shares in your portfolio is probably quite low.

Although US stocks have outperformed most non-US developed markets as a whole over the past 10-year period, this does not mean that this has always been the case ─ or that it will continue in the future. For example, over the period January 1, 1970 through July 2022, Hong Kong, Denmark, Sweden, the Netherlands and Switzerland have all had higher average returns than the US stock market. Despite the smaller size of their economies, the example helps illustrate the importance of diversification, as there is often another country than the best performing one.

Am I not getting enough international exposure with multinational companies?

While investors gain some foreign exposure from investing in multinational companies (generally defined as a company that generates at least 25 percent of its revenue outside its home market), in the sense that these companies benefit from economic growth abroad, investors should own foreign stocks, for several reasons.

Multinational companies tend to represent some parts of the global industry and not others. For example, by only owning US multinationals, investors are likely to end up in a variety of technology and healthcare companies. But they would be underrepresented in other important parts of the global economy, such as basic materials.

In addition, most US multinationals fall into the Large Cap category, those companies with USD 10 billion or more in market capitalization. Research has shown that the benefits of international diversification are greatest when investing in smaller companies, and that international small-cap stocks helped diversify equity portfolios for US investors more than large-cap stocks. US multinationals provide little exposure to international equities from an investment return perspective, even when a high proportion of revenues come from foreign sales.

Investing outside your own market: putting risk into perspective, looking for opportunities

Although the benefits of investing internationally are widely accepted, many investors are still reluctant to invest abroad, mainly because they believe that investing abroad is much riskier. It is important for investors to understand some of the primary global investment risks, such as currency, political risks, interest rates and liquidity. While individual countries’ markets may be more volatile/risky than their own domestic market, historical data shows that investing globally can result in similar volatility to the stock market in your own country, which may be surprising to many investors.

For many investors, “maximum drawdown” or significant market decline is a more intuitive way to define risk over a given period. It is defined as the maximum loss in a peak-to-valley decline before a new peak is reached.

What is the right mix of international exposure over the long term?

While there may be short-term fluctuations in the performance of international equities, in the long term we believe it makes sense to maintain international exposure. One of the methods we use is something called Modern Portfolio Theory (MPT). MPT suggests investing in the global market, with each asset class weighted to its market capitalization. The US market is ~61% of the global market, so according to MPT, an investor should have ~61% of their capital invested in the US and the rest (~39%) in non-US stocks.

However, each investor’s needs are different. Getting the right balance of international exposure over the longer term depends on both rigorous process and historical experience. Asset allocation is one of the most important decisions investors make.

The volatility of a portfolio initially consisting only of US – or Swedish – stocks decreases as foreign stocks are added to the portfolio in stages. Historically, portfolio risk is minimized when non-US stocks represent between 35% and 40% of total equity exposure, reflecting a potential optimal diversification point.

Another reason to own international stocks over the long term is that valuations are more attractive abroad. Academic studies show that below-average valuations for international stocks today suggest above-average returns over the next 15-20 years. This means that non-US shares are priced at a discount to their US counterparts. Cheaper valuations now for these stocks suggest that they have the potential to deliver above-average returns over the long term. However, this was changed by the uncertain economic and political environment during the COVID-19 pandemic, with investors paying a premium for the lower volatility and more stable, predictable returns offered by US equities.

How do you decide how much exposure to developed versus emerging markets you should have?

There are some compelling reasons to make allocations to emerging markets. For starters, they represent around 11% of global market capitalization. There has been a significant increase in growth in emerging markets over the last 10 years. Historically, emerging markets have delivered higher average returns, albeit with higher volatility, than developed markets. The data also shows that individual emerging markets are relatively uncorrelated between countries, so the risk of investing in all countries as a group (against individual countries) is lower.

Need more information?

We’ve touched on the basics of investing in international stocks and some of the short- and long-term issues and opportunities to be aware of. If you want to know more about how international investments affect your managed portfolio, make an appointment to talk to your advisor or portfolio manager.

Taxation of foreign shares

Foreign shares are taxed like ordinary Swedish shares, but it is important to remember that if the foreign shares you buy pay dividends, they should be placed in an endowment insurance policy in the first instance and not in an investment savings account.

The same applies to ETFs, so-called exchange-traded funds. In the case of this instrument, it is also an advantage that they are domiciled in Ireland, as the dividends are completely tax-free. Do not confuse where the exchange-traded fund is domiciled with where it is traded. In Europe, most exchange-traded funds are traded on the Xetra exchange in Germany even if they are domiciled in Ireland, the Netherlands or Germany.

The process of investing in foreign shares and ETFs

Investing in foreign shares and ETFs requires that you first create an account with a broker. After your account has been activated, you can transfer money from your Indian bank account to the broker’s bank account. After the funds have been credited to your broker’s account, the broker will enable trading in foreign shares. Is that all it takes? Wait, wait, wait. This is only a simplified version of the process. Let’s see it in more detail, along with some of the problems you are likely to face.

Currency conversion: Investing in foreign shares and ETFs involves converting Swedish kronor into a foreign currency, such as the US dollar.

Should you invest in foreign shares directly?

Although international funds have lost the index benefit, investing directly in foreign stocks and ETFs may not be the right choice for most private investors. In addition to the hassles discussed above, you must also have the knowledge of picking stocks in overseas markets. Keeping up to date with international markets and companies is not everyone’s cup of tea. Therefore, only enterprising investors who are willing to do the necessary work should consider investing directly in foreign markets.

For the rest who want to diversify into foreign markets, international equity funds such as exchange-traded funds are still the best option due to their long-term costs.

Reasons to include foreign investments in your portfolio

The US currently represents 60% of the global stock market, Sweden around 1%. This means that investors with an extreme home bias ignore a large part of the equity universe. In fact, it would have worked for you to do so for the last 14.5 years, but markets are cyclical, so this is unlikely to last forever. Especially in today’s challenging market environment, investors should think twice before giving foreign assets the cold shoulder.

No stock market dominates forever

The US does not always dominate the global stock market! When US stocks face headwinds, foreign stocks can rise to the occasion. Sustained periods of over-performance by a region have been quite common historically.

These seizures can be significant. Consider, for example, the ‘lost decade’ for US stocks that started in the early 2000s. Between 2000 – 2009, the cumulative total return of the S&P 500 was negative 9.1% compared to positive 30.7% for the MSCI All Country World Index ex U.S..

International stocks can outperform if US stocks struggle

The graph above shows the performance of the S&P 500 vs MSCI EAFE. During periods of below-average returns on domestic stocks, international stocks outperformed, by more than 2% on average. Further, in all rolling 10-year periods since 1971, the best performer was almost a coin toss: the US only did better 56% of the time.

Since trying to time regime changes is very difficult in real time without the benefit of hindsight, there is reason to consider allocating both domestic and foreign equities to an asset allocation.

Foreign shares can help reduce risk in a portfolio

Having international exposure in your portfolio in the early 2000s and throughout the global financial crisis would have been a key ingredient in reducing overall risk and maintaining a certain level of investment returns.

As an example, consider this hypothetical 60/40 portfolio of stocks to bonds. The U.S. only portfolio includes the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index while the U.S. and International portfolio allocates 20% of equity exposure to the MSCI All-Country World Index ex-U.S.

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