For the longest time, index funds have been touted as some of the safest investments because they’re inherently diversified and low-cost despite providing attractive returns in the long run. However, it’s not always clear whether these benefits extend to international index funds. If you’re considering going international with your index fund investment and aren’t sure whether that’s the right way to go, this is a post you don’t want to skim through.
International index funds are a good investment for investors with moderate-to-high risk profiles. They enhance portfolio diversification, provide a safer way to invest overseas companies than stocks, and allow investors to harness global economic growth more effectively than S&P 500 index funds.
Read on for in-depth coverage of the pros and cons of investing in international index funds, who should take this investment route, and how much they should allocate.
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Advantages of Investing in International Index Funds
Investing in international index funds can be advantageous in the following ways:
- It takes portfolio diversification to a whole new level.
- It’s a better way to harness global economic growth than holding an S&P 500 index fund.
- It’s a safer way to invest in overseas companies than purchasing individual stocks.
Let’s delve deeper into these claims in the next section.
Enhancing Portfolio Diversification
Generally, investing in a domestic index fund provides instant diversification because these funds typically hold a broader mix of securities than you can possibly assemble in an individual portfolio.
So when you buy one share of an index fund, you’re actually buying smaller portions of many securities, which is great for diversification.
However, holding international index funds adds an extra dimension to portfolio diversification.
Since international markets don’t always fall and rise at the same time as the US market, holding a mix of domestic and international index funds can level out some of your portfolio’s volatility. Lowering portfolio volatility decreases risk, which is the whole point of diversification.
A More Effective Way To Harness Global Economic Growth
For the longest time, investors have used S&P 500 index funds as an avenue to international diversification.
As a quick reminder, the S&P 500 is one of the stock market indexes, and you can’t invest directly in it. It tracks the performance of 500 large-cap companies in the US.
On the other hand, S&P 500 index funds are funds designed to mimic the performance of the S&P 500 closely. These two terms can get confusing at times, so I thought to clear things up before we proceed.
Back to what I was saying…
Like many other investors, you probably are holding an index fund in your portfolio, too, and are thinking that you’ve got international portfolio diversification covered. In all fairness, this line of reasoning makes sense.
After all, the companies index funds invest in may be US-based, but they derive a significant chunk of their revenue from foreign markets 一29%, to be precise.
But while that’s fine for a start, holding an S&P index fund is somewhat “the easy way out” when it comes to international diversification.
Why is this considered the easy way out? Because S&P index funds are some of the most pocket-friendly investments in terms of fees, with expense ratios averaging less than 0.1%.
For instance, Vanguard 500 Index Fund Admiral Shares (VFIAX) had an expense ratio of 0.04% as of 04/29/2021. Meanwhile, its Exchange Traded Fund (ETF), Vanguard S&P 500 ETF (VOO), has an expense ratio of 0.03%, with the average ratio for similar funds standing at 0.83%. Both ratios are well below 0.1%.
As with any other “easy way out,” there’s a compromise that comes with using an S&P index fund to gain exposure to foreign markets. Put simply, this kind of index fund holds companies that make most of their revenue in the US.
Remember earlier when I mentioned that the underlying companies in an S&P 500 index fund generate 29% of their revenue in foreign markets?
That also means that 71% of their revenue is generated in the US. So while investing in an S&P 500 index fund still gives you some exposure to international markets, your earnings depend way more on the domestic market.
International index funds, on the other hand, are primarily invested in foreign markets such as South America, Asia, Europe, Africa, and North America. So by investing in one of these, you get a better chance to harness market upturns in global markets for portfolio growth.
A Safer Way To Invest in Overseas Companies Than Stocks
Generally, index funds carry less risk than individual stocks because they’re inherently diversified. This also applies when investing in overseas companies.
An international index fund’s portfolio typically has tens or hundreds of different holdings spread across various markets. And as with a domestic index fund, the asset mix is designed to mimic the performance of a specific overseas market index.
In addition to reducing risk through diversification, international index funds also make it safer to invest in overseas companies by eliminating guesswork in picking investments.
The holdings of such funds are carefully chosen by professional fund managers (who may be supported by a team of experts such as analysts) to match the returns and risk of the underlying market index.
In most cases, a professional fund manager will have way more expertise to make investment decisions than the average investor. The more informed these decisions are, the lower the chances of making costly mistakes.
Having an expert make investment decisions on your behalf can be particularly helpful when investing internationally.
That’s because more often than not, you won’t know companies outside the US well enough to choose the least risky ones to invest in.
Potential Drawback of International Index Funds
International index funds come with pretty much the same drawbacks as a domestic index fund. Since today’s post is all about the former, we won’t go into the disadvantages of conventional index funds.
Instead, let’s focus on the drawback that’s specific to foreign index funds. This comes in the form of the volatility stemming from currency fluctuations.
Like any other foreign market investment, an international index fund may lose value due to a change in the foreign country’s currency value.
If the currency is highly volatile, it can add significant risk to your investment. Luckily, you can dampen the impact of such volatility by choosing foreign index funds hedged in USD.
Who Should Invest in International Index Funds?
Despite their advantages, international index funds aren’t ideal for all investors. They’re more suited to investors with moderate-to-high risk profiles.
Typically, this would be someone who has built a sizable portfolio with US-based securities and funds.
So if you’re just getting started, you might want to avoid international index funds at this stage of your investment journey.
And even after you’ve been in the game for a while and built a significant portfolio, you’ll want to allocate between 10% and 20% to these types of funds.
That is, under 15% allocation if you have a moderate risk profile and 15%-20% if you have a higher risk appetite.
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Conclusion
All said and done, international index funds are a solid investment for investors looking for exposure to foreign markets or hoping to enhance portfolio diversification. In addition, international index funds provide investors with an effective way to harness global economic growth.
While they carry some risk, you can mitigate most of it by choosing index funds hedged in USD. It also helps to choose an international index fund that matches your risk profile, budget, and portfolio size.
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