International Investing: Go Japan!

Investing in foreign stocks is an important element of portfolio diversification. Since it’s difficult to buy and sell stocks on foreign exchanges, the best way to invest is with mutual funds or ETF’s (exchange traded funds). But there’s an odd quirk in the way foreign stock index funds choose how much to invest in each country.   It’s based on the size of each countries stock market, not on the size of the country’s economy. For example, a popular international mutual fund (VTMGX) has 24% of assets invested in Japan, and 19% in the United Kingdom. However, Japan’s economy (GDP) is only 8% of the international total, and the U.K.’s economy is 5%.

To determine the best way to invest internationally, it’s helpful to remember that international investments make sense because of the diversification they add. In the ideal scenario, international investments would go up when U.S markets go down, and vice versa. That would allow us to earn the higher returns that stock markets offer without huge drops in our total portfolio. It’s not that perfect in the real world, but the diversification foreign markets add is still important.

In order to maximize diversification we might simply invest equal amounts in several foreign countries, regardless of the size of their stock market or economy. I tested this strategy from 2001 through 2014 using 16 ETF’s, each representing a different foreign country. The results were striking, with the equal weight strategy returning an average of almost 9% per year and an international mutual fund returning just over 5%. The volatility of the equal weight strategy was slightly higher than a mutual fund, but this is mostly due to higher returns in many years and less due to deeper losses.

This strategy can be taken one step further by investing only in the best foreign country ETF’s. Although the definition of what the “best” foreign countries to invest in will vary from manager to manager, I have created what I believe is a reasonable approach. The newly launched “Foreign Value” strategy invests in 15 foreign country funds of about 23 currently available. Given the discussion above, I am optimistic that this will be a better approach than buying a single mutual fund.