Portfolio perspectives

International equities: Will the performance continue?

In a Portfolio perspectives piece earlier this year, we acknowledged advisors’ frustrations with international equity performance over the past 15 years. We made the case that the uncertainty and cyclicality of returns of international stocks relative to U.S. stocks is the first rationale for the inclusion of international stocks in a U.S. investor’s portfolio. The uncertainty, combined with the potential benefits of diversification, forms the most compelling argument for including international equities in an investment portfolio.

When international equities began to outperform U.S. equities in February of this year, the tenor of our conversations with advisors shifted from whether to allocate to international equity at all to “what is an appropriate allocation?” and its frequently asked corollary, “will outperformance versus the U.S. persist?”

The exact allocation to U.S. and non-U.S. stocks is less important than having a reasonable allocation to both.

Historically, the inclusion of international equities has reduced the volatility of the equity allocation within a portfolio. Figure 1 indicates that the optimal diversification may be achieved with a 40% allocation to international equities. However, most of the reduction in portfolio volatility occurs with the first 20% to 30%, with diminishing per-unit benefits thereafter.

However, it's important to note that most assets and sub-asset classes will experience significant periods of underperformance. This may require advisors to defend the rationale for these investments, focusing on uncertainty of future returns and the potential benefits of diversification. There will be days, months, even years where one investment outperforms the other, and the question will linger—will its current outperformance persist?

It's worth remembering that U.S. equity hasn’t always been in the lead. It seems like a distant memory, but the lost decade of the 2000s (bookended by the tech crash and global financial crisis) saw the S&P 500 Index return −1% on an annualized basis, versus 3% for the MSCI ACWI ex-US.

This year, we’ve seen international equities outperform from the end of 2024 through the middle of May by around 15%.¹ Many advisors asked if we should expect that outperformance to continue. Over the last couple months, there has been a small reversal, but we can see in Figure 2 that historically, when one category has outperformed over the course of a year, that outperformance tends to persist.

While this analysis offers some basis for expecting international to outperform U.S. in subsequent periods—as might looking at current relative valuations—predicting the best-performing market remains challenging. It may prove more productive to focus on the potential benefits of diversification, one of Vanguard’s foundational principles for investment success.  An additional potential benefit of a global allocation is an exposure to a different mix of industries, companies, and currencies than a U.S. equity-only portfolio. Vanguard’s report, Not all great stocks are found in the U.S. markets, addresses the different company exposures that international equities offer, and it can be shared with your clients.

Next steps to consider: Does your international allocation meet your overall portfolio objectives?

• Is low-cost beta a core objective of your portfolio? If so, consider these options:
  • A broadly diversified index fund or ETF such as Vanguard Total International Stock ETF (VXUS).
  • For those clients whose risk tolerance does not extend to emerging markets or when you want to control their emerging markets exposure, a developed markets fund or ETF such as Vanguard FTSE Developed Markets ETF (VEA) alone or paired with Vanguard FTSE Emerging Markets ETF (VWO).

• Is income an overarching objective?
  • Consider the premium dividend yield of international stocks such as the index used by Vanguard International High Dividend Yield (VYMI).
• Is quality a focus?
  • Consider the defensive properties of a dividend growth index such as the S&P Global Ex-U.S. Dividend Growers Index, used by Vanguard International Dividend Appreciation ETF (VIGI).
• Is active management a preference for targeting international exposure?
  • Vanguard partners with some of the most experienced investment managers in the world as subadvisors on our active funds. For instance, the Wellington-managed “all weather” International Core Stock Fund, VZICX, incorporates a multi-disciplinary approach that leverages the strengths of an extended investment team.