Foreign stocks can offer substantial diversification benefits when their economic cycles and valuations differ from those experienced in the U.S. International markets are also diverse, with the major stock indexes and economies of different regions and countries often not being highly correlated with each other.

While investors have the option of investing in foreign firms directly on U.S. exchanges through American depositary receipts (ADRs), building a globally diversified portfolio using stocks is not simple. Mutual funds and exchange-traded funds (ETFs) are better for achieving true international diversification.

Benefits of Adding International Funds

Funds can offer broad exposure to foreign companies and markets. Those categorized as international stock funds invest primarily in the common stock of foreign firms; they seek to obtain long-term growth of invested capital and may provide income. Some funds may specialize in regions and others invest worldwide. Funds labeled as global funds, in contrast, invest in the common stock of both foreign and U.S. securities.

Like all mutual funds, international and global stock funds can potentially invest in a large number of securities, giving you a cost-effective way to own shares in many different companies.

International stock funds typically hold shares of companies domiciled and listed in different countries and across different industries. This can offer investors multiple layers of diversification—including geographical, currency and sector—thus reducing the chances that the performance of a single stock or instability in a single country can negatively impact the performance of the entire portfolio.

International stock funds have the potential to offer greater capital appreciation than domestic stock funds. However, that increased potential comes with greater risk. International funds may also offer a broader variety of corporate attitudes toward paying dividends compared to funds investing solely in U.S. stocks. For those saving for retirement or other long-term goals, this kind of growth potential can be key to helping your savings keep pace with inflation.

Professional portfolio managers and analysts have the expertise, technology, global reach and language skills needed to research foreign companies. They can also have the ability to trade on foreign exchanges. This level of expertise and access are difficult, if not impossible, for most individual investors to achieve.

In some foreign markets, securities trade with much less frequency. All mutual funds allow you to buy or sell your fund shares at each business day’s closing net asset value (NAV). You can also automatically reinvest any income from dividend and capital gains distributions or make additional investments at any time. The required minimum initial investment may also be substantially less than what you would have to pay to build a diversified portfolio of individual stocks. ETFs trade on an intraday basis, like stocks. Depending on the markets they target, ETFs targeting foreign markets can trade at bigger premiums or discounts to their NAV relative to domestically focused ETFs.

Risks of International Investing

Mutual funds and ETFs holding securities trading on foreign exchanges have additional risks compared to their U.S. counterparts. In some cases, these factors can cause greater volatility of stock prices and thereby fund performance.

A country with stable finances and a relatively strong economy is likely to provide a more reliable investing environment than a country with weaker finances or an unsound economy.

Hostile regimes, political instability and government actions that are unfriendly to investors could present a risk. For example, iShares, Franklin Templeton and Van Eck all suspended trading of their Russian market ETFs after Russia invaded Ukraine.

The exchange rate between a country’s currency and the U.S. dollar fluctuates constantly if the currency is not pegged. This can impact the dollar value of an investment, even if the security’s price remains unchanged. In some cases, though, currency fluctuation can boost the returns of a fund investing in international securities. This would happen if the dollar’s value falls relative to other currencies.

In many cases, foreign markets and the stocks issued by foreign companies are not as widely followed by U.S. financial analysts. This can present an opportunity for active fund managers to use research capabilities to potentially identify and take advantage of less-known securities.

Country risk can be diversified by investing either in a mutual fund that holds many countries or in an assortment of single-country funds. Currency risk can be tempered to some extent by investing in a mutual fund or ETF that diversifies among countries with different currencies.

AAII’s three Asset Allocation Models allocate between 10% and 30% to foreign stocks. This type of exposure is needed to have a meaningful impact on your portfolio from a diversification standpoint and help mitigate risks.

International Stock Representation in the AAII Allocation Models

If you are using mutual funds or ETFs to invest internationally, make sure you know the percentages that are allocated to the different countries and regions. Many fund managers overweight and underweight certain regions and countries at various times.

In the AAII Asset Allocation Models, the Vanguard Developed Markets Index Fund Admiral Shares (VTMGX) mutual fund—and its ETF counterpart, the Vanguard Developed Markets Index ETF (VEA)—to represent international equity holdings. Both of these funds fall within the foreign large blend category and track the investment performance of the FTSE Developed All Cap ex U.S. Index as can be seen in Tables 1 and 2.

Table 1. Top Foreign Large-Cap Mutual Funds by Category (Ranked by 5-Year Return)

Download the Excel spreadsheet.

Table 2. Top Foreign Large-Cap ETFs by Category (Ranked by 5-Year Return)

Download the Excel spreadsheet.

The FTSE Developed All Cap ex U.S. Index is a market-capitalization-weighted index representing the performance of large-, mid- and small-cap companies in developed markets, excluding the U.S. The index is derived from the FTSE Global Equity Index Series, which captures 98% of the world’s investable market cap.

Foreign large blend funds invest in a variety of big international stocks. Most of these funds divide their assets among a dozen or more developed markets, including Japan, Britain, France and Germany. Primarily, these funds invest in stocks that have market caps in the top 70% of each economically integrated market (such as Europe or Asia ex-Japan). Nestle, Unilever and Nintendo are examples of widely held foreign large-cap companies.

The blend style is assigned to funds where neither growth nor value characteristics dominate. These funds typically have less than 20% of assets invested in U.S. stocks.

The aforementioned Vanguard mutual fund and ETF have region allocations of about 50% Europe, 36% Pacific and 10% North America, with the remainder invested in the Middle East and other countries. In total, the fund is diversified across 24 countries. By country, Japan holds the highest market allocation as a percentage of common stock at about 21%. It is followed by the U.K. at around 14%, Canada at around 10% and France and Switzerland both at around 8%.

While the Vanguard fund and ETF are among the top 15 foreign large-cap blend funds, among mutual funds and ETFs respectively, when ranked by five-year return, they are not the top performers.

On the mutual fund side, the Goldman Sachs International Equity ESG Investor Class (GIRNX) fund leads with an 11.7% annualized five-year return. This fund stands out in its one-year annualized return, which is far above its category average. It may be that the “ESG” in the Goldman Sachs fund’s name is particularly helping its return, considering investors’ intrigue with environmental, social and governance considerations and fund managers’ desire to appeal to customers. The fund favors Europe more than the Vanguard Developed Markets Index fund, with a 75% region allocation. Japan represents the majority of the non-European markets for the fund, with an allocation of 16%. However, the fund’s largest country-specific allocation is to the U.K., at about 28%.

While the Vanguard fund is an index fund, the Goldman Sachs fund is not. If you are specifically looking for index mutual funds for passive investing, those options are check-marked in Table 1.

Looking at the ETFs, the iShares MSCI International Quality Factor ETF (IQLT) leads the foreign large-cap blend category with a five-year annualized return of 9.8%. Its top five geographic allocations are similar to those of the mutual funds discussed above, with the U.K. at 14%, Switzerland at 14%, Japan at 13%, France at 9% and Canada at 8%.

The broad differences seen in returns across domestic growth and value categories can also be seen internationally. The mutual fund and ETF growth categories of foreign large-cap have outperformed the value categories over the last five years. However, there is a reversal in category leadership when looking at one-year annualized returns. The two foreign large-cap growth categories have negative one-year annualized returns compared to the two foreign large-cap value categories’ positive one-year annualized returns.

As the category performances show, style diversification is also important to keep in mind when selecting an international mutual fund or ETF.

Conclusion

If you invest in an international mutual fund or ETF, you’re increasing your portfolio’s diversification by getting access to hundreds of foreign securities. Funds offer a better option for international diversification than ADRs by providing exposure to a larger universe of companies, including those traded only on foreign exchanges.

Markets outside the U.S. don’t always rise and fall at the same time as the domestic market, so owning both international and domestic securities can level out some of the volatility in your portfolio. This can spread out your portfolio’s risk more than if you owned only domestic securities.

International investing should be a long-term commitment. It is difficult to know which region or country will do well over any particular time period. Don’t sell out of more volatile regions on bad news. If you think you might be tempted to do so, avoid the more volatile areas.

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