In the classic investment book Stocks for the Long Run (4^th ed.), Wharton finance professor Jeremy Siegel explained the importance for U.S. residents to invest not only in the stocks of U.S.-based companies but in foreign stocks as well (page 168):

The reason to invest internationally is to diversify your portfolio and reduce risk. Foreign investing provides diversification in the same way that investing in different sectors of the domestic economy provides diversification. It would not be good investment policy to pin your hopes on just one stock or one sector of the economy. Similarly, it is not a good policy to buy the stocks only in your own country, especially when developed economies are becoming an ever smaller part of the world’s market.

International diversification reduces risk because the stock prices of one country often rise at the same time those of another country fall, and this asynchronous movement of returns dampens the volatility of the portfolio.

According to the MSCI All-Country World Index (ACWI), stocks in the U.S. account for only 46.74% of the world’s stock market capitalization. That means that a U.S. investor who only invests in U.S.-based companies is missing out on more than half of the world’s economic growth! When one considers that annual U.S.GDP growth is currently only 1.7% — compared to 8% in China, 6% in Indonesia, and 5% in India – the detrimental effect of not investing in the rest of the world becomes even more glaring.  In his 2005 book The Future for Investors (page 236), Professor Siegel recommends that U.S. investors allocate 40 percent of their equity portfolio to foreign stocks.

This allocation is 13 percentage points less than the 53% global market weighting of non-U.S. stocks because of foreign exchange risk. Over short periods of time, foreign currencies can depreciate against the U.S. dollar, which will cause foreign stocks denominated in those foreign currencies to be worth less U.S.-dollar terms. Of course, foreign currencies can also appreciate in value, but losses are more damaging than gains are beneficial, so the potential downside risk outweighs the potential upside benefit.

Over the long term, however, Siegel argues that foreign exchange risk is not important and long-term investors need not hedge the risk, either by lowering foreign equity exposure below the 53% market weighting or through the purchase of derivatives (e.g., currency put options):

In the long run, exchange-rate movements are determined primarily by differences in inflation between countries, a phenomenon called purchasing power parity.  Since equities are claims on real assets, their long-term returns have compensated investors for changes in inflation and thus protected investors from exchange-rate risk. Therefore, it is not worth the cost for long-term stock investors to hedge their currency risk.

Brazil illustrates this point. Since 1992, the Brazilian currency has depreciated more than eighty times relative to the dollar, but this was more than compensated for by appreciation of Brazilian stocks. Brazilian stock prices held up well because when inflation hits, investors run to tangible assets, such as real estate, precious metals, and stocks. The impact on foreign investors of the depreciating currency is offset by the rising of output and increasing profit margins, as wages generally lag inflation.

                [Stocks for the Long Run (page 173), Future for Investors (page 233)]

Despite the diversification benefits of allocating 40 percent to foreign stocks, the average U.S. investor only has a 14-percent allocation to foreign stocks – 2/3rds less than recommended! Why so low? The answer is an irrational behavior known as “home equity bias” which has been an “important yet unresolved empirical puzzle in financial economics since the 1970s.” Simply put, people favor the familiar over the unfamiliar and are willing to sacrifice additional risk-adjusted profit for this familiar feeling. The bias is a universal human attribute which one 2005 study was able to document existed in each of the 48 developed and emerging markets across the globe that it vetted. Of course, some investor fear of the unfamiliar may be justified due to foreign exchange fluctuations, higher transaction costs, accounting fraud (China), and political corruption (Russia), but the bias is much larger than all of these issues collectively warrant. Furthermore, the greater the home equity bias in a country, the cheaper the country’s equity valuations.

Bottom line: those investors who successfully avoid home equity bias not only improve the diversification of their portfolios, but also take advantage of the bias of others by purchasing undervalued foreign shares.

The rationale for foreign diversification extends to the small-cap stock universe. If you take a look at historical equity style returns in the 10-year period between 2003 and 2012, foreign small-cap stocks outperformed both U.S. small-cap growth and U.S. small-cap value in six of the ten years. The correlation between international small caps and U.S. small caps is surprisingly low (page 17) – even lower than the correlation of international small caps and U.S. large caps or U.S. small caps and U.S. large caps!

Index Correlations

 (Jan. 2000–Sep. 2012)

According to a 2007 Brandes Institute report (page 36), the reason why foreign small caps and U.S. small caps have such low correlations is because they are fundamentally different U.S. small caps are typically young start-ups whereas foreign small caps are typically much older and more established:

Perhaps the origins of small-cap companies are different across regions.  For example, within the small-cap segment in Europe, there may be a greater number of companies spun off from mature firms vs. business conceived and launched as start-ups. Results presented here confirm that European small caps are indeed the oldest of the world’s small caps, as measured by average age since incorporation.  Extending that theme, if one thinks in terms of a company’s “lifecycle,” there likely is a greater number of North American small-cap firms in the earlier, rapid-growth stages of their existence.

Whereas U.S. large caps and foreign large caps have experienced relatively high correlations since the 2008 financial crisis, the correlations between U.S. small caps and foreign small caps have remained low.  The reason, as Boston-based investment firm Lee Munder explains, has to do with the exclusively domestic focus of small caps in their respective countries vs. the uniform international business focus of large caps:

The superior diversification benefits from small-caps are primarily due to those stocks being more highly correlated with their domestic economies than larger multi-national stocks which tend to have higher correlations with other countries including the U.S. Therefore, international small-cap stocks offer more country diversification compared to larger multi-national stocks in either the developed or emerging market universes.

With the explosive development of the middle class in emerging markets, domestic-focused foreign small caps will offer U.S. investors the highest growth in the world. Investment firm Lord Abbett explains:

A burgeoning middle class is projected to fuel tremendous demand for the products and services of well-managed industry leaders, whose average market cap is smaller than in developed nations, particularly in the Asia-Pacific region. According to Ernst & Young, another three billion people could join this demographic by the year 2030, most of them in Asia. The implications for increased spending are staggering. As the Organization for Economic Co-operation and Development (OECD) put it in a 2010 report, the middle class in Asia-Pacific spent just under $5 trillion in 2009; by 2030, that figure could rise to almost $33 trillion, which would amount to an impressive compound annual growth rate of 9.4%.

For all these reasons (high returns, low correlations, and middle-class growth in emerging markets), a December 2011 report by Russell Investments concluded:

International small cap is a promising asset class, just beginning to be considered for inclusion in a broadened global equity portfolio. While developed large and mid cap companies will continue to constitute the bulk of international allocations, in the next decade investors are expected to slowly integrate non-U.S. small cap as they move toward fully realized global equity portfolios

Year-to-date, the nine best-performing foreign small-cap stocks with market caps of at least $200 million are listed below:

Best-Performing Foreign Small Caps

Source: Bloomberg