[This article appears in our January 2022 issue of ETF Report.]
Although the U.S. large cap equity market continues its dominance over the rest of the world, financial advisors are starting to add ex-U.S. allocations to portfolios.
In its 2022 outlook, UBS summed up what a number of financial advisors are thinking: U.S. outperformance over global peers is unlikely to continue into the next decade because of valuations, making now the time to diversify.
“We believe a globally diversified equity allocation will be a key contributor to both portfolio growth and income in the years ahead,” the bank stated.
UBS isn’t alone. Morgan Stanley advocates overweighting Japanese and European equities. Japan’s stocks, the bank suggests, are “on a journey of return on equity convergence with the rest of the world,” while in Europe, Morgan Stanley forecasts double-digit total return based on potentially “higher earnings per share, currency tailwinds … low investor positioning and limited valuation downside.”
Advisors Adding Ex-US Allocations
Several financial advisors say they’ve started adding international equity allocations to tactical positions for the first time in a few years for the above reasons, and some are including ex-U.S. fixed income holdings to boost yield.
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Portfolio weightings depend on the client’s time horizon and risk tolerance, they say. It’s not always easy to convince clients though, even when advisors explain the U.S. represents only 15% of the global economy. Part of it is a reluctance to sell winners—in this case, U.S. large cap equities—and another part of it is unfamiliarity with foreign markets.
Robert Gilliland, managing director and senior wealth advisor at Concenture Wealth Management, says investors might think international investing means investing in obscure companies: “We remind them it’s companies like Nestle and Unilever, products that they’re buying every day.”
Curtis Congdon, president, XML Financial Group, concurs. His clients tolerate 5-10% in international holdings, but expanding beyond that level can be difficult.
Gilliland generally prefers putting at least 8% of the equity portfolio in international holdings, but if clients are willing, he’ll target weights closer to 15-20% in a portfolio that’s 60-65% stocks. The easiest way to start adding ex-U.S. holdings is systematically, such as through dollar cost averaging, he adds.
Big & Liquid
To add core international exposure, many of the advisors say they use two of the biggest ETFs by assets under management and best-known foreign stock index funds: the iShares Core MSCI EAFE ETF (IEFA), and the iShares Core MSCI Emerging Markets ETF (IEMG).
David McGranahan, financial advisor at Relative Value Partners, says his firm uses IEFA and IEMG in their static allocation strategies. This strategy earmarks 20% to international as part of the overall equity position. For context, their broadest allocation across their balanced accounts is 60% equities, 40% bonds.
These funds are broadly diversified and low cost. “Our allocations are modest enough that it’s really going to offer exposure to the markets, exposure to their GDP growth, their productivity growth and currencies,” he noted.
Gilliland also uses IEFA and IEMG for index-based non-U.S. exposure, but likes some specialized exposure. For that, he’ll use the American Century Quality Diversified International ETF (QINT) and the First Trust S&P International Dividend Aristocrats ETF (FID).
Dividend ETFs can offer a hedge against inflation, he notes, although many people don’t equate international exposure and dividends: “I think you’re going to find that dividends will become increasingly important, especially to investors here in the U.S. You have to have that international exposure, but you don’t necessarily have to give up that income.”
Relative Value Partners also runs a tactical allocation strategy where exposure can rise or fall, and that strategy now has international positions versus none a few years ago, says Greg Neer, partner and portfolio manager at the firm. The tactical allocation now holds 12% developed non-U.S. and 6% emerging markets, using the iShares ETFs.
Daniel Milan, managing partner of Cornerstone Financial Services, says five of his firm’s model portfolios always keep some sort of international holdings, although in the last few years, the models were underweight international versus benchmarks.
For his aggressive-growth models that have 85% equities, 5% alternatives and 10% fixed income, 18% of the equity sleeve is earmarked ex-U.S., with 10% of that figure focused on Europe and 8% slated to other diversified large foreign markets.
Milan settled on that mix based on vaccine rates, which were higher in Europe and Great Britain than other parts of the non-U.S. globe. To express his view, Milan uses the First Trust Europe AlphaDex Fund (FEP) and the iShares MSCI Intl Quality Factor ETF (IQLT).
He wants to be overweight quality in the current economic environment. “You want companies that are going to have the strongest balance sheets, the most stability in uncertain times from a business standpoint or economic standpoint,” he pointed out.
Currency exposure is another facet of international investing, Congdon says. If he expects the U.S. dollar to weaken against a basket of foreign currencies, he may use a fund that has no currency hedge, such as the iShares MSCI EAGE ETF (EFA). If he doesn’t want currency to impact performance, he might consider the iShares Currency Hedged MSCI EAFE ETF (HEFA).
EM Still Iffy For Equities
Not all advisors are ready to jump into emerging market equities. Milan says the dollar is currently too strong for him to allocate to the sector in equities.
When weighing between U.S., international developed and emerging markets, Congdon considers several factors, including earnings growth, valuations, economic growth within the home country and yield. Specific to emerging markets, he studies the policy climate, meaning how favorable policy is to innovation, property rights and the ease of doing business.
Relative Value Partners uses the SPDR S&P Emerging Markets Dividend ETF (EDIV) for emerging markets, Neer says, noting the ETF screens firms for dividend growth, stability and profitability. Companies with those types of attributes “make us feel more comfortable in the [firm’s] underlying accounting,” he explains.
The ETF gives exposure to traditional commodity-based emerging market firms, rather than the “growthier” areas of emerging markets, such as in tech. The dividend-paying firms “also tend to have a value bias, which is how we like to position ourselves,” he adds.
Fixed Income Ideas
A few advisors are using emerging market debt to boost yield and for diversification.
Gilliland uses the Invesco Emerging Markets Sovereign Debt ETF (PCY), a U.S.-dollar-based index, and he’s also evaluating the First Trust TCW Emerging Markets Debt ETF (EFIX). He admits the latter ETF is riskier, as it’s an actively managed fund investing in lower quality bonds.
The advisors who use emerging market debt vehicles keep them to 5-7% of the total fixed income sleeve, depending on a client’s risk tolerance.
Congdon and Milan will sometime use the First Trust Emerging Markets Local Currency Bond ETF (FEMB), a local currency ETF, and Congdon also uses the SPDR Bloomberg International Treasury Bond ETF (BWX), which he says holds investment-grade sovereign debt.
Congdon explains that, for advisors venturing into this sector, keep in mind it’s riskier than domestic markets. He views the space as a hybrid between stocks and bonds.
“The return profile isn’t going to exactly meet either one of those two categories, but could fit between them and have a place within the portfolio,” he noted.