Foreign Currency Impact

An additional variable for US-based investors owning international stocks is the impact of foreign currencies. US investors experience higher returns from their international holdings when the US dollar depreciates relative to the foreign currency of the international stocks they own. Given the weakness of the US dollar relative to many currencies this year, this has juiced the returns of foreign stocks. In fact, the year-to-date move in currencies provided 9.3 percentage points of the 11.9 percentage points of outperformance of the MSCI ACWI Ex-US over the S&P 500.

The year-to-date boost to international investments is unlikely to be repeated if history is any guide. In fact, foreign exchange has reduced the returns of US-based investors in foreign stocks over the past twenty years. Even the emerging market stock index that benefited the most from currency tailwinds only gained 68.7% over twenty years, due to foreign currency exposure, which equates to a 3% annualized gain resulting from currency translation. Despite the currency help, the S&P 500 outpaced emerging markets stocks by a wide margin.

While some might extoll the virtues of currency diversification, most US investors have their liabilities almost exclusively in US dollars. Thus, an extensive currency mismatch between assets and liabilities should be viewed as a risk, not a positive attribute.

International Diversification

Diversification is protection against ignorance. It makes little sense if you know what you are doing. – Warren Buffett

Many academics and some practitioners argue that US investors suffer from a home country bias, as they do not own a sufficient number of international stocks to aid in diversification. They consider a market capitalization-weighted allocation to be a proper baseline, which suggests that US stocks should comprise 49% of a stock portfolio, according to their calculations.

Beyond ignoring the foreign exchange risk, this argument overlooks the reality that the US occupies a privileged position relative to most countries. The US benefits from an embrace of capitalism and the rule of law. Furthermore, our markets are already fully diversified across sectors, which is not the case for all countries. Because many of our US companies are global leaders and competitors, over 40% of the revenues for the S&P 500 are sourced internationally, allowing investors to gain international exposure by holding large-cap US stocks.

International: Betting Against Technology?

Another lens to consider is that an allocation to international indexes is a bet against technology. The S&P 500 is 35% technology, while the foreign markets’ tech weighting is 14%. Instead, the international markets have a significantly higher exposure to financial companies and banks than the US.

It is fair to argue that focusing solely on the technology sector overlooks the actual impact of technology leaders in the US. Adding Amazon (AMZN), Meta Platforms (META), and Alphabet (GOOGL) to the mix increases the technology-related US exposure to 46%.

The US is fortunate to be home to many of the world’s leading technology companies. While it can be debated whether technology is where you want to be overweight at the moment, those considering international index investing should be aware of the inherent wager in making that move.

US Versus International Stock Valuation

Another argument used by some advocates for international investing is that valuations are cheaper than in the US. The forward estimated price-to-earnings ratio is 14.7 times for international stocks versus the US’s 22.1 times. While the valuation is lower, US stocks should trade at a higher valuation due to a superior return on equity, which measures the earnings that a company produces from the capital provided by shareholders.

US companies also have superior profit margins, which is the percentage of revenue that ends up as bottom-line profits. The US technology sector is a crucial reason why the S&P 500 boasts exceptional profitability.

There can be reasonable disagreements about the size of the valuation premium appropriate for US stocks. Still, the mere fact that international stocks as a whole are cheaper is necessary but not sufficient to argue for sustained outperformance from them.

Blueprint For International Investing

The five very successfully operate in a manner somewhat similar to Berkshire itself. – Warren Buffett referring to Berkshire Hathaway’s investment in the Japanese trading companies.

Although the US has a large share, there are well-managed and dominant companies domiciled outside the country. Rather than a predetermined percentage allocation of a stock portfolio with international stocks, investors should seek specific opportunities worldwide, while being mindful of the additional risks associated with foreign currencies and particular locales.

Even though he primarily invests in US securities, Warren Buffett’s Berkshire Hathaway (BRK/A, BRK/B) can provide a good example. Berkshire Hathaway initially announced the acquisition of about 5% of five Japanese trading companies at the end of August 2020. These holdings are Itochu Corp., Marubeni Corp., Mitsubishi Corp., Mitsui & Co. Ltd., and Sumitomo Corp. In Buffett’s 2024 annual letter, he noted that all five companies had agreed to relax the previously agreed-upon 10% ownership ceiling. At the recent annual meeting, Buffett said he “won’t give a thought” to selling them and expects Berkshire to own them for fifty years or more. Berkshire now owns around 10% of each of these trading companies. Interestingly, Buffett mitigated the foreign exchange risk associated with these companies being traded in Japanese Yen by having Berkshire Hathaway issue Yen-denominated bonds, thereby better currency-matching assets and liabilities.

While individual investors can’t issue foreign-currency-denominated bonds, currency-hedged investments are available to mitigate currency risk. For example, WisdomTree Japan Hedged Equity ETF (DXJ) provides exposure to dividend-paying Japanese stocks, currently including most of Buffett’s Japanese trading houses, while hedging the currency to remove as much of the Yen-currency risk as possible. Alternatively, a non-currency-hedged individual foreign stock position can be perfectly reasonable if it presents an attractive opportunity, even when considering the currency, political, legal, and regulatory risks of the country.