As an investor, I often hear the argument that sticking to U.S. stocks is the safest bet. But is that really true? Over the past few decades, international index funds have gained traction as a way to diversify and capture global growth. In this article, I’ll explore whether international index funds are a good investment, examining their benefits, risks, historical performance, and how they fit into a long-term portfolio.
Table of Contents
What Are International Index Funds?
International index funds are passively managed funds that track a basket of stocks from countries outside the U.S. They provide exposure to developed markets (like Europe and Japan) and emerging markets (like China and India). Unlike actively managed funds, which try to beat the market, index funds aim to replicate the performance of a benchmark, such as the MSCI EAFE (Europe, Australasia, Far East) or MSCI Emerging Markets Index.
Key Characteristics:
- Low Costs: Expense ratios are typically lower than actively managed funds.
- Diversification: Spreads risk across multiple economies.
- Passive Management: No reliance on fund managers’ stock-picking skills.
Historical Performance: U.S. vs. International Markets
One common argument against international investing is that U.S. stocks have outperformed global markets in recent years. But history shows this isn’t always the case.
Table 1: U.S. vs. International Stock Returns (1970-2023)
| Period | U.S. (S&P 500) | International (MSCI EAFE) |
|---|---|---|
| 1970-1979 | 5.9% | 10.3% |
| 1980-1989 | 17.5% | 22.0% |
| 1990-1999 | 18.2% | 7.4% |
| 2000-2009 | -1.4% | 1.2% |
| 2010-2019 | 13.6% | 5.3% |
| 2020-2023 | 14.1% | 6.8% |
Source: Bloomberg, MSCI
From this table, we see that international stocks outperformed U.S. stocks in the 1970s and 1980s but lagged in recent decades. This cyclicality suggests that diversification helps mitigate long-term risks.
The Case for International Index Funds
1. Diversification Reduces Risk
Modern Portfolio Theory (MPT) states that combining uncorrelated assets reduces overall portfolio volatility. The correlation between U.S. and international stocks is not perfect, meaning they don’t always move in sync.
\sigma_p = \sqrt{w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2w_1w_2 \sigma_1 \sigma_2 \rho_{1,2}}Where:
- \sigma_p = portfolio volatility
- w_1, w_2 = weights of U.S. and international stocks
- \sigma_1, \sigma_2 = standard deviations
- \rho_{1,2} = correlation coefficient
If \rho_{1,2} < 1, adding international stocks can lower overall risk.
2. Valuation Discounts
As of 2023, international stocks trade at lower price-to-earnings (P/E) ratios than U.S. stocks.
Example:
- S&P 500 P/E: ~22x
- MSCI EAFE P/E: ~14x
This suggests international markets may offer better value.
3. Currency Diversification
Holding assets in foreign currencies can act as a hedge against dollar depreciation. If the USD weakens, international holdings gain in relative value.
The Case Against International Index Funds
1. Higher Costs and Taxes
While expense ratios are low, some international funds have additional costs:
- Foreign withholding taxes (often 15-30% on dividends).
- Higher trading costs due to less liquid markets.
2. Political and Economic Risks
Emerging markets face instability, currency controls, and governance issues. Developed markets like Europe and Japan have slower growth than the U.S.
3. Underperformance in Recent Decades
Since 2010, U.S. tech dominance (Apple, Amazon, Microsoft) has driven outperformance. Investors who avoided international markets benefited.
How Much Should You Allocate to International Stocks?
There’s no one-size-fits-all answer, but common strategies include:
- Market-Cap Weighting: Allocating based on global market share (U.S. ~60%, International ~40%).
- Fixed Allocation: E.g., 70% U.S., 30% International.
Table 2: Historical Risk-Return Tradeoff (1970-2023)
| Allocation (U.S./Intl) | CAGR | Max Drawdown |
|---|---|---|
| 100%/0% | 10.2% | -50.9% |
| 80%/20% | 9.8% | -49.1% |
| 60%/40% | 9.5% | -47.3% |
| 40%/60% | 9.1% | -45.5% |
Source: Portfolio Visualizer
A 20-40% international allocation historically reduced drawdowns without drastically lowering returns.
Practical Considerations
1. Which Funds to Choose?
- Developed Markets: VEA (Vanguard FTSE Developed Markets).
- Emerging Markets: VWO (Vanguard FTSE Emerging Markets).
- Total International: VXUS (Vanguard Total International Stock).
2. Tax Efficiency
Holding international funds in tax-advantaged accounts (IRA, 401k) minimizes tax drag from foreign dividends.
Final Verdict: Are International Index Funds Worth It?
I believe they are—but with caveats.
Pros:
- Diversification benefits.
- Potential valuation upside.
- Hedge against U.S.-specific risks.
Cons:
- Recent underperformance.
- Additional costs.
- Complexity for some investors.
For long-term investors, a 20-30% allocation to international index funds makes sense. The key is staying disciplined—chasing past performance (U.S. stocks) often leads to future underperformance.
